From Actual to Risk-Neutral Default Probabilities: Merton and Beyond

Abstract

Practitioners frequently price credit instruments using real world quantities (PD, EL) and adding a risk premium. This paper analyzes these credit risk premia implied by structural models of default. We first analyze a Merton framework and find that i) credit risk premia constitute a significant part of model-implied spreads and ii) this part increases with increasing credit quality. In addition, credit risk premia are hardly affected by moving to more advanced structural models of default. However, two drivers can be identified: The default timing effect - credit risk premia are lower if the conditional default time is small - and the asset value uncertainty effect - credit risk premia are higher for a higher asset value uncertainty.

Keywords: credit spreads, risk premia, structural models of default, unobservable asset values

JEL Classification: G12, G13