NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Amiyatosh Purnanandam

University of Michigan
Ross School of Business
D4208, 701 Tappan Street
Ann Arbor,MI 48109

E-Mail: EmailAddress: hidden: you can email any NBER-related person as first underscore last at nber dot org
Institutional Affiliation: University of Michigan

NBER Working Papers and Publications

May 2019Bank Risk Dynamics and Distance to Default
with Stefan Nagel: w25807
We adapt structural models of default risk to take into account the special nature of bank assets. The usual assumption of log-normally distributed asset values is not appropriate for banks. Typical bank assets are risky debt claims, which implies that they embed a short put option on the borrowers’ assets, leading to a concave payoff. This has important consequences for banks’ risk dynamics and distance to default estimation. Due to the payoff non-linearity, bank asset volatility rises following negative shocks to borrower asset values. As a result, standard structural models in which the asset volatility is assumed to be constant can severely understate banks’ default risk in good times when asset values are high. Bank equity payoffs resemble a mezzanine claim rather than a call option. ...
 
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