FEDERAL FINANCIAL GUARANTEES AND THE OCCASIONAL MARKET PRICING OF DEFAULT RISK - EVIDENCE FROM INSURED DEPOSITS

This paper develops a two-date state preference model which demonstrates that investors' valuation of third-party guaranteed debt depends on the financial condition of the guarantor. As the solvency ratio of the guarantor declines, investors demand higher promised rates on the firm's debt securities and price the firm risk variables more sensitively. The empirical results are derived from sample data of FSLIC guaranteed obligations from the late 1980s. Evidence shows differences in the market's perception of FSLlC's insolvency between 1987 and 1988. The market response to a decline in the financial condition of the guarantor affected the value of insured CDs, raising CD rates in relation to the Treasury curve and firm risk pricing of insured deposits emerged. © 1991.