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Adverse Selection, Moral Hazard and the Term Structure of Default

by Koresh Galil of the Goethe University of Frankfurt & Tel-Aviv University

March 2004

Abstract: This paper estimates the term structure of the hazard rate to default by using two hazard models - one ignoring and another allowing unobserved heterogeneity and annual shocks to the hazard rate. Diamond (1989) predicts a declining hazard rate to default due to adverse selection and moral hazard. The adverse selection effect is confirmed. After controlling for adverse selection, the hazard rate shows to be increasing over time and hence the moral hazard effect cannot be confirmed. The paper contributes also to the credit risk literature by providing a tool to gap between the immediate and long-term default probabilities.

JEL Classification: G10, G12, G14, G20.

Keywords: Credit Risk, Adverse Selection, Moral Hazard, Survival Analysis, Unobserved Heterogeneity.

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