The Credit Market Handbook: Advanced Modeling Issues

Executive Chapter Summaries

CHAPTER 1 ESTIMATING DEFAULT PROBABILITIES IMPLICIT IN EQUITY PRICES

Tibor Janosi, Robert Jarrow, and Yildiray Yildirim

This chapter uses a reduced-form credit risk model to estimate default probabilities implicit in equity prices. The equity return model developed includes the possibility of default, market risk premiums, and price bubbles. For a cross section of firms, this equity return model is estimated using monthly returns in a time-series regression. Three conclusions are obtained. First, the analysis supports the feasibility of estimating default probabilities implicit in equity returns. This new estimation procedure provides a third alternative to using either structural models with equity prices or reduced-form credit risk models with debt prices for estimating default probabilities.

Second, we find that equity returns contain a bubble component not captured by the traditional Fama–French four-factor model for equity’s risk premium. This bubble component, proxied by the firm’s price-earnings ratio, is significant for many of the firms in our sample.

Third, due to noise introduced in equity returns by price bubbles and market risk premium, the estimated default probabilities may confound these quantities, giving biased estimates with large standard errors.

Indeed, the default probabilities obtained herein are larger than those previously obtained using either logit models based on historical data or those obtained implicitly from debt prices. ...