Pricing the Risks of Default

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Madan, Dilip B. and Haluk Unal, "Pricing the Risks of Default", Review of Derivatives Research, (December 1998), Vol. 2, No. 2-3, pp 121-160.

Abstract: This paper decomposes default risk into timing and recovery risks. The two default components are explicitly priced as if they were traded in the futures market. We develop estimation strategies evaluating recovery risks and then construct implicit prices of contingent securities reflecting purely the timing risk. The models are estimated on monthly data for rates on certificates of deposit offered by institutions in the Savings and Loan Industry, during the 1987–1991 period. Empirical results support market expectations of lower likelihoods of default after 1989.

Keywords: hazard rate, default timing, recovery risk.

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