“Cross‐sectional Dispersion, Expected Loan Losses, and Debt Cycles” by Cross‐sectional Dispersion, Expected Loan Losses, and Debt Cycles
Dr. Gil Sadka
Associate Professor of Accounting
University of Texas at Dallas
Debt holders face a concave payoff function. Well‐performing borrowers pay back predetermined interest and principal, while poor‐performing borrowers may cause significant losses. Consequently, the expected losses on a portfolio of loans/bonds depend not only on the mean performance of borrowers but also on the cross‐sectional dispersion in borrowers’ performance. Higher dispersion suggests higher expected losses due to a larger number of poor ‐performing borrowers and higher loss given default. Thus, for debt holders, aggregate economic conditions or business cycles should be redefined as a function of both the mean borrowers’ performance and the cross‐sectional dispersion in borrowers’ performance. Empirical analysis of loan and bond portfolios confirm our hypotheses.