
 Separating the Components of Default Risk: A DerivativeBased Approach (Job Market Paper) by Anh Le of New York University January 16, 2007 Abstract: In this paper, I propose a general pricing framework that allows the riskneutral dynamics of loss given default (L^{ Q }) and default probabilities (λ^{ Q }) to be separately and sequentially discovered. The key is to exploit the differentials in L^{ Q }exhibited by different securities on the same underlying firm. By using equity and option data, I show that one can efficiently extract pure measures of λ^{ Q }that are not contaminated by recovery information. Equipped with this knowledge of pure default dynamics, prices of any defaultable security on the same firm with nonzero recovery can be inverted to compute the associated L^{ Q }corresponding to that particular security. Using data on credit default swap premiums, I show that, crosssectionally, λ^{ Q }and L^{ Q }are positively correlated. In particular, this positive correlation is strongly driven by firms' characteristics, including leverage, volatility, profitability and qratio. For example, 1% increase in leverage leads to .14% increase in λ^{ Q }and .60% increase in L^{ Q }. These findings raise serious doubts about the current practice, by both researchers and practitioners, of setting L^{ Q }to a constant across firms. Previously titled: Credit Information from Equity Option Prices 