Abstract

We estimate default measures for US banks using a model capable of handling volatility clustering like those observed during the global financial crisis. To capture time variation in volatility, we develop a GARCH option pricing model which extends the seminal structural approach of default by Merton (1974) and calculates distance to default" indicators in a more responsive way to heightened market developments. We also adopted an approximate exact formula for the GARCH option model to keep the numerical calculation at a minimum and make the overall estimation still practical. Our results show that estimation with these richer volatility dynamics greatly improves default measures during the heightened volatility episode observed in the course of the Global Financial Crisis, yielding distance to default probabilities for the sampled 138 large U.S. banks as high as 28% in sharp contrast to only 9% under the industry standard KMV-Merton model.

Turalay Kenc earned his PhD in economics at the University of York in the United Kingdom and has held academic positions at a number of UK universities including the University of Cambridge, Birkbeck College at the University of London, the University of Durham, the University of Manchester and Imperial College London. Former Deputy Governor at the Central Bank of the Republic of Turkey.