Pricing the Risks of Default
October 1996

by
Dilip B. Madan
Haluk Unal

Abstract: This paper models default risk as composed of arrival and magnitude risks. In
our model the two default components are explicitly priced as if they were traded in the
futures market and the spot price of risky debt is derived as a consequence. We develop
estimation strategies to evaluate the magnitude risks which are then employed to construct
implicit prices of pure arrival risk contingent securities. The latter prices are used to
estimate the structure of arrival risks. The models are estimated on monthly data for rates
on certificates of deposit offered by institutions in the Savings and Loan Industry, during
the 1987-1991 period. Empirical results support market expectations of lower likelihoods of
default after 1989.