Asset Liquidity, Debt Valuation, and Credit Risk

This paper presents a structural debt valuation model that links default probabilities and recovery rates of corporate securities to asset market liquidity. This linking is advantageous for risk management and regulation of financial institutions in that it provides a method of calibrating the relationship between probability of default (PD) and loss given default (LGD). Two innovations in the paper are the placing of the default point in a model of debt valuation into general equilibrium and conditioning this point on market factors such as asset liquidity. These allow one to derive implications on the correlation between various components of the model. Specifically, it finds two relationships between the probability of default (PD) and loss given default (LGD) of a debt instrument; temporal correlations are positive and cross-sectional ones negative. Such findings confirm the intuition of existing reduced form approaches and provide the ability to inspect other properties of the relationship that derive from theory. For example, one can use the model to forecast LGD. Some empirical validation of the theoretical results is provided. ∗Federal Reserve Bank of Boston. 600 Atlantic Avenue, Boston, MA 02210. 617.973.3294. email: [email protected]. I am grateful for helpful comments from Max Bruche, Kimberly DeTrask, Jon Frye, Jose Lopez, Todd Prono, seminar participants at the Federal Reserve System’s committee on financial structure and regulation, ISCTE/NOVA and at the FMA. I am particularly grateful to Ed Altman for sharing his data. As well, I am indebted to Nick Kraninger and Jonathan Larson for outstanding research assistance. An earlier version of this paper was circulated under the title "Joint Causation, A Structural Model Explaining the Probability of Default Recovery Rate Link." The views expressed in this paper are solely those of the author and do not reflect official positions of the Federal Reserve Bank of Boston or the Federal Reserve System.