Implied Probabilities of Default from Colombian Money Market Spreads: The Merton Model under Equity Market Informational Constraints

Abstract

Informational constraints may turn the Merton Model for corporate credit risk impractical. Applying this framework to the Colombian financial sector is limited to four stock-market-listed firms; more than a hundred banking and non-banking firms are not listed. Within the same framework, firms' debt spread over the risk-free rate may be considered as the market value of the sold put option that makes risky debt trade below default-risk-free debt. In this sense, under some supplementary but reasonable assumptions, this paper uses money market spreads implicit in sell/buy backs to infer default probabilities for local financial firms. Results comprise a richer set of (38) banking and non-banking firms. As expected, default probabilities are non-negligible, where the ratio of default-probability-to-leverage is lower for firms with access to lender-of-last-resort facilities. The approach is valuable since it allows for inferring forward-looking default probabilities in the absence of stock prices. Yet, two issues may limit the validity of results to serial and crosssection analysis: overvaluation of default probabilities due to (i) spreads containing non-credit risk factors, and (ii) systematic undervaluation of the firm's value. However, cross-section assessments of default probabilities within a wider range of firms are vital for financial authorities' decision making, and represent a major improvement in the implementation of the Merton Model in absence of equity market data.

Requerimientos macroprudenciales de capital y riesgo sistémico : una aplicación para Colombia

“…No obstante, las entidades que deben incrementar su capital tienen mejores indicadores de riesgo, siendo en promedio 1 pp inferior su indicador de calidad y de mora a los indicadores del resto de bancos. Al igual que en Leon (2012) se encuentra que los bancos subcapitalizados están en promedio más apalancados. Nota: * Estas columnas se calculan como la diferencia entre el indicador y su promedio.…”

“…Adicionalmente, la metodología utilizada por estos autores limita el estudio al grupo de bancos que listan en bolsa, dejando por fuera del análisis otras instituciones que podrían ser importantes en términos de su interconexión. Sin embargo, Leon (2012) extiende el modelo de Merton a instituciones financieras que no cotizan en bolsa, utilizando la información de spreads en el mercado monetario, encontrando que las instituciones más apalancadas son las que cuentan con una mayor probabilidad de default.…”

Modular scale-free architecture of Colombian financial networks : evidence and challenges with financial stability in view

“…If the connective pattern and hierarchical structure of financial markets are the result of selforganized criticality, where small changes yield frequent small consequences and exceptional 53 Interestingly, Adam Smith may be credited for the first view of the economy as a complex adaptive system, where the "invisible hand" is nothing but the self-organization emerging from independently acting economic agents. 54 As documented in León et al (2012), the crisis that begun about 2007 display the disproportionate effect of a shock in the overall properties of the system, where there is some degree of consensus about the lack of correspondence between the subprime crisis (i.e. the shock) and the global financial crisis (i.e.…”

Macro-prudential assessment of Colombian financial institutions' systemic importance

“…Several authors have addressed the importance of the sovereign sell/buy backs for characterizing the local money market (e.g. Martínez and León, 2013;León, 2012;Cardozo et al, 2011). For instance, after excluding Central Bank's repos, sovereign securities sell/buy backs are the most important source of liquidity among financial institutions, with 2010, 2011 and 2012 daily average value of transactions around 83% of the total, whereas repos between financial institutions account for about 1%, and non-collateralized borrowing around 16%, respectively.…”

“…the buyer becomes the seller), where the property of the collateral is transferred to its buyer. Under local regulation, unlike repos, haircuts and mobility limitations are not imposed on collateral, which may explain why Colombian financial firms prefer sell/buy backs to other sources, including repos with the Central Bank during some periods(León, 2012).19 Not considering non-sovereign securities collateralized markets is due to data limitations. However, based on approximate figures, in 2012 79% of collateralized money market transactions (i.e.…”