Underpriced Default Spread Exacerbates Market Crashes

• Main Authors: KOH, Winston T. H., MARIANO, Roberto S. S, PAVLOV, Andrey, PHANG, Sock Yong, TAN, Augustine H. H., WACHTER, Susan M.
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2006
• Subjects: real estate bubble; lender optimism; disaster myopia; Asian financial crisis; Economics; Finance
• Online Access: https://ink.library.smu.edu.sg/soe_research/1898; https://ink.library.smu.edu.sg/context/soe_research/article/2897/viewcontent/UnderpricedDefaultSpreadExacerbatesMarketCrashes.pdf
• Institution: Singapore Management University

In this paper, we develop a specific observable symptom of a banking system that underprices the default spread in non-recourse asset-backed lending. Using three different data sets for 18 countries and property types, we find that, following a negative demand shock, the “underpricing” economies experience far deeper asset market crashes than economies in which the put option is correctly priced. Furthermore, only one of the countries in our sample continues to exhibit the underpricing symptom following a market crash. This indicates that market crashes have a cleansing effect and eliminate underpricing at least for a period of time. This makes investing in such markets safer following a negative demand shock.