A 'default strike' is my recasting of the Merton model. Namely, a cost of funding for an entity above which that entity risks insolvency. Interests rates have been close to zero for well over a decade, when the average time to maturity for corporate debt is 2-3 years. Many, if not most, corporate re-funding is subject to a massive shock. In the Merton model for default, the key input for the distance to default is determined by expected return less expected volatility of the underlying total company value (debt + equity). In a rising rate environment return expectations fall and expected volatility rises, which reduces the distance to default. So, the 'default strike' has been brought closer-to-the-money for many entities.
What breaks next? Foreign debtors of Chinese banks are clear risk. Closer to home, pension funds, insurance companies and real estate funds are prime candidates.
What are ‘default’ strikes?
What do you think breaks next?
A 'default strike' is my recasting of the Merton model. Namely, a cost of funding for an entity above which that entity risks insolvency. Interests rates have been close to zero for well over a decade, when the average time to maturity for corporate debt is 2-3 years. Many, if not most, corporate re-funding is subject to a massive shock. In the Merton model for default, the key input for the distance to default is determined by expected return less expected volatility of the underlying total company value (debt + equity). In a rising rate environment return expectations fall and expected volatility rises, which reduces the distance to default. So, the 'default strike' has been brought closer-to-the-money for many entities.
What breaks next? Foreign debtors of Chinese banks are clear risk. Closer to home, pension funds, insurance companies and real estate funds are prime candidates.
Oh, and watch out for private equity.