Model Implied Credit Spreads

Abstract

I propose a new procedure for extracting probabilities of default from structural credit risk models based on model implied credit spreads (MICS) and implement this approach assuming a barrier option framework nesting the Merton (1974) model of capital structure. MICS are the increase in the payout to debt-holders necessary to oset the impact of an increase in asset variance on the option value of debt and equity. In contrast to real-world credit spreads, MICS do not contain risk premia for default timing and recovery uncertainty, thus yielding a purer estimate of physical default probabilities. Relative to a standard distance to default (DD) measure, my measure (i) predicts higher credit risk for safe rms and lower credit risk for rms with high volatility and leverage (ii) requires fewer parameter assumptions (iii) clearly outperforms the DD measure when used to predict corporate default.

Keywords: Structural Credit Risk Models, Bankruptcy Prediction, Risk-Neutral Pricing

JEL Classification: G33, G13, G32