Explaining Credit-Ratings through a Perpetual-Debt Structural Model

Abstract

In this article we calibrate a Perpetual-Debt Structural Model (PDSM) by using Moody’s historical credit-ratings. In the PDSM, stocks are equivalent to a portfolio that contains a perpetual American option to default and bonds are perpetual securities whose face value plays the role of a “notional” capital used to calculate the amount of interests due in the unit of time.

The key question is whether PDSM can generate (real-world) default probabilities consistent with those historically estimated by Moody’s, under empirically reasonable parameter choices. The answer is ‘yes’. The paper also contains an application at the level of a single listed firm: Deutsche Bank. The PDSM risk indicators have been used to assign a credit rating consistent with Moody’s scale.

Keywords: Credit, Banking, Risk Management

JEL Classification: G13