Measuring The Probability Of Default And Recovery Rate On Bonds And Options

1122 Words Sep 24th, 2015 5 Pages
While much work has been done on measuring the probability of default and recovery rate on bonds and options, much less have been done on bank loans. Yet bonds and bank loans are monitored differently. While loans are monitored by bank managers, bonds must be monitored by the public who holds them. There is a dichotomy of information between the two. Where the bank has superior resources and information of their borrower, bondholder usually does not. Thus there is a monitoring advantage of banks over bondholders (Diamond 1984). Recently, there has been a growth in loan securitization. This have brought about a fear of monitoring deterioration and moral hazard behavior. Loan securitization could give the bank the opportunity of getting rid of “lemon” loans and keep only the good quality loans. However, moral hazard can be mitigated, and banks still have a monitoring advantage compared to public bonds (Altman, Gande, Saunders, 2010). In fact Altman et al. found evidence that loan returns Granger cause bond returns before firm defaults on its loans. Altman & Suggitt (2000) assess the default rate experience on large, syndicated bank loans. According to them, the most fundamental aspect of credit risk models is the rating of the underlying credit asset and the associated expected and unexpected risk migration patterns. The mortality rates on bank loans are extremely similar to corporate bonds, but loan default rates appear to be noticeably higher than bonds for the first two…

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