The Economic Default Time and the Arcsine Law

by Xin Guo of the University of California, Berkeley,
Robert A. Jarrow of the Cornell University & Kamakura Corp., and
Adrien de Larrard of the Laboratoire de Probabilités et Modèles Aléatoires

January 21, 2011

Abstract: This paper develops a structural credit risk model to characterize the difference between the economic and recorded default times for a firm. Recorded default occurs when default is recorded in the legal system. The economic default time is the last time when the firm is able to pay off its debt prior to the legal default time. It has been empirically documented that these two times are distinct (see Guo, Jarrow, and Lin (2008)). In our model, the probability distribution for the time span between economic and recorded defaults follows a mixture of Arcsine Laws, which is consistent with the results contained in Guo, Jarrow, and Lin. In addition, we show that the classical structural model is a limiting case of our model as the time period between debt repayment dates goes to zero. As a corollary, we show how the firm value process's parameters can be estimated using the tail index and correlation structure of the firm's return.

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