Pricing in Nonliquid Markets

Abstract

Default risk is the uncertainty surrounding a firm’s ability to honor its debts and obligations. Prior to default, there is no way to know for certain which firms will default and which will not, so assessments can only be made on the likelihood of default. As a consequence, firms generally pay a spread over the default-free rate of interest that is proportional to their default probability to compensate lenders for this uncertainty. Default is a deceptively rare event; however, there is considerable variation in default probabilities across firms.1 The loss suffered by a lender or counterparty in the event of default is usually significant and is determined largely by the details of the particular contract or obligation. For example, typical loss rates in the event of default for senior secured bonds, subordinated bonds and zero coupon bonds are 49, 68 and 81 percent, respectively. As in other rare events with high costs, default risk can only be managed effectively in a portfolio. In addition to knowing the default probability and loss given default, the portfolio management of default risk requires the measurement of default correlations. Correlations measure the degree to which the default risks of the various borrowers and counterparties in the portfolio are related.KeywordsCredit RiskEuropean Central BankDefault RiskDefault ProbabilityDefault RateThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.