Measuring Default Risk from Market Prices*
The previous chapter discussed how to quantify credit risk into credit ratings from actuarial methods. Credit risk can also be assessed from market prices of securities whose values are affected by default. These include corporate bonds, equities, and credit derivatives. In principle, these should provide more up-to-date and accurate measures of credit risk because financial markets have access to a very large amount of information and are forward-looking. Agents also have very strong financial incentives to impound this information in trading prices. This chapter shows how to infer default risk from market prices.
Section 21.1 will show how to use information about the market prices of credit-sensitive bonds to infer default risk. In this chapter, we call defaultable debt interchangeably “credit-sensitive,” “corporate,” and “risky” debt. Here risky refers to credit risk and not market risk. We show how to break down the yield on a corporate bond into a default probability, a recovery rate, and a risk-free yield.
Section 21.2 turns to equity prices. The advantage of using equity prices is that they are much more widely available and of much better quality than corporate bond prices. We show how equity can be viewed as a call option on the value of the firm and how a default probability can be inferred from the value of this option. This approach also explains why credit positions are akin to short positions in options and are ...