Default Risk in Stochastic Volatility Models

CER-ETH (Center of Economic Research at ETH Zurich) Working Paper No. 10/131

25 Pages Posted: 28 Aug 2010

See all articles by Hans Gersbach

Hans Gersbach

ETH Zurich - CER-ETH -Center of Economic Reseaarch; IZA Institute of Labor Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Nicolae Surulescu

affiliation not provided to SSRN

Date Written: June 2010

Abstract

We consider a stochastic volatility model of the mean-reverting type to describe the evolution of a firm’s values instead of the classical approach by Merton with geometric Brownian motions. We develop an analytical expression for the default probability. Our simulation results indicate that the stochastic volatility model tends to predict higher default probabilities than the corresponding Merton model if a firm’s credit quality is not too low. Otherwise the stochastic volatility model predicts lower probabilities of default. The results may have implications for various financial applications.

Keywords: stochastic volatility, Merton model, default probabilities, rate of mean reversion

JEL Classification: G13, G21, G32

Suggested Citation

Gersbach, Hans and Surulescu, Nicolae, Default Risk in Stochastic Volatility Models (June 2010). CER-ETH (Center of Economic Research at ETH Zurich) Working Paper No. 10/131. Available at SSRN: https://ssrn.com/abstract=1666782 or http://dx.doi.org/10.2139/ssrn.1666782

Hans Gersbach (Contact Author)

ETH Zurich - CER-ETH -Center of Economic Reseaarch ( email )

Zürichbergstrasse 18
Zurich, 8092
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IZA Institute of Labor Economics

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Germany

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Nicolae Surulescu

affiliation not provided to SSRN ( email )

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