Explaining Credit-Ratings through a Perpetual-Debt Structural Model
23 Pages Posted: 12 Jan 2016 Last revised: 2 Apr 2020
Date Written: May 31, 2020
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
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