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
Date Written: June 2010
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: Suggested Citation