Default Risk under Different Colours of Noise

  •  Dror Parnes    


In this study we theoretically simulate default risk scenarios under various economic noises. We find that firms default more quickly with stronger economic shocks but simultaneously expose higher default probabilities during their deterioration, offering traders better visibility. When the macroeconomic environment exhibits positive autocorrelation, the volatility of assets’ value increases with corporate creditworthiness, and vice versa. While positive autocorrelation forces liquidation more swiftly even for firms with higher risk tolerance, counter-cyclical economic movements reduce default risk for firms with greater sustainability. When a series of economic noises exhibits higher autocorrelation, although average default probabilities decline, firms tend to default more rapidly, making it tougher for traders to predict corporate failure.

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