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Model Implied Credit Spreads

50 Pages Posted: 14 Oct 2011  

Gunnar Grass

HEC Montréal

Date Written: October, 13 2011

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

Suggested Citation

Grass, Gunnar, Model Implied Credit Spreads (October, 13 2011). Paris December 2011 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=1943573 or http://dx.doi.org/10.2139/ssrn.1943573

Gunnar Grass (Contact Author)

HEC Montréal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H3T2A7
Canada
5143401540 (Phone)

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