Credit Spreads with Dynamic Debt

53 Pages Posted: 26 Sep 2013 Last revised: 25 Sep 2015

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Seoyoung Kim

Santa Clara University

Date Written: July 16, 2014

Abstract

This paper extends the baseline Merton (1974) structural default model, which is intended for static debt spreads, to a setting with dynamic debt, where leverage can be ratcheted up as well as written down through pre-specified exogenous policies. We provide a different and novel solution approach to dynamic debt than in the extant literature. For many dynamic debt covenants, ex-ante credit spread term structures can be derived in closed-form using modified barrier option mathematics, whereby debt spreads can be expressed using combinations of single barrier options (both knock-in and knock-out), double barrier options, double-touch barrier options, in-out barrier options, and one-touch double barrier binary options. We observe that debt principal swap down covenants decrease the magnitude of credit spreads but increase the slope of the credit curve, transforming downward sloping curves into upward sloping ones. On the other hand, ratchet covenants increase the magnitude of ex-ante spreads without dramatically altering the slope of the credit curve. These covenants may be optimized by appropriately setting restructuring boundaries, which entails a trade-off between the reduction in spreads against restructuring costs. Overall, explicitly modeling this latent option to alter debt leads to term structures of credit spreads that are more consistent with observed empirics.

Keywords: Credit spreads, dynamic debt, ratchet, restructure, guarantee, barrier options

JEL Classification: G1, G13, G19

Suggested Citation

Das, Sanjiv Ranjan and Kim, Seoyoung, Credit Spreads with Dynamic Debt (July 16, 2014). Journal of Banking and Finance, Vol. 50, 2015. Available at SSRN: https://ssrn.com/abstract=2330569 or http://dx.doi.org/10.2139/ssrn.2330569

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://algo.scu.edu/~sanjivdas/

Seoyoung Kim (Contact Author)

Santa Clara University ( email )

500 El Camino Real
Santa Clara, CA California 95053
United States

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