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A. Le, “Separating the Components of Default Risk: A Derivative-Based Approach,” (Working paper, New York University, 16 January 2007).

A. Le, “Separating the Components of Default Risk: A Derivative-Based Approach,” (Working paper, New York University, 16 January 2007).

Abstract: In this paper, I propose a general pricing framework that allows the risk neutral dynamics of loss given default (LQ) and default probabilities (∏Q) to be separately and sequentially discovered. The key is to exploit the differentials in LQ exhibited by different securities on the same underlying Ørm. By using equity and option data, I show that one can efficiently extract pure measures of ∏Q that are not contaminated by recovery information. Equipped with this knowledge of pure default dynamics, prices of any default able security on the same Ørm with non-zero recovery can be inverted to compute the associated LQ corresponding to that particular security. Using data on credit default swap premiums, I show that, cross-sectionally,∏Q and LQ are positively correlated. In particular, this positive correlation is strongly driven by Ørms’ characteristics, including leverage, volatility, profitability and q-ratio. For example, 1% increase in leverage leads to .14% increase in ∏Q and .60% increase in LQ. These Endings raise serious doubts about the current practice, by both researchers and practitioners, of settingLQto a constant across Ørms