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Estimating Expected Losses and Liquidity Discounts Implicit in Debt Prices

by Tibor Janosi of Cornell University,
Robert Jarrow of Cornell University, and
Yildiray Yildirim of Cornell University

Fall 2002

Abstract: This paper provides an empirical implementation of a reduced form credit risk model that incorporates both liquidity risk and correlated defaults. Liquidity risk is modeled as a convenience yield and default correlation is modeled via an intensity process that depends on market factors. Various different liquidity risk and intensity process models are investigated. Firstly, the evidence supports a non-zero liquidity premium that is firm specific, reflecting idiosyncratic and not systematic risk. Secondly, the credit risk model with correlated defaults fits the data quite well with an average R2 of .87 and a pricing error of only 1.1 percent.

Published in: Journal of Risk, Vol. 5, No. 1, (Fall 2002), pp. 1-38.

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