Explaining Credit Ratings Through a Perpetual-Debt Structural Model

26 Pages Posted: 23 Aug 2021

See all articles by Gaia Barone

Gaia Barone

School of Business, National College of Ireland

Multiple version iconThere are 2 versions of this paper

Date Written: July 4, 2019

Abstract

In this paper, 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 interest due in the given unit of time. The key question is whether the 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 are used to assign a credit rating to the firm that is consistent with Moody’s scale.

Keywords: structural credit risk models; endogenous default boundary; first-touch digital options; stochastic equity volatility; model calibration; credit default swaps.

Suggested Citation

Barone, Gaia, Explaining Credit Ratings Through a Perpetual-Debt Structural Model (July 4, 2019). Journal of Credit Risk, Vol. 17, No. 2, Available at SSRN: https://ssrn.com/abstract=3908025

Gaia Barone (Contact Author)

School of Business, National College of Ireland ( email )

Mayor Street
IFSC
Dublin, 1
Ireland

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