Model Implied Credit Spreads

Gunnar Grass

Cahiers de recherche from CIRPEE

Abstract: I propose a new measure of credit risk, model implied credit spreads (MICS), which can be extracted from any structural credit risk model in which debt values are a function of asset risk and the payout ratio. I implement MICS assuming a barrier option framework nesting the Merton (1974) model of capital structure. MICS are the increase in the payout to creditors necessary to offset the impact of an increase in asset variance on the option value of debt. Endogenizing asset payouts, my measure (i) predicts higher credit risk for safe firms and lower credit risk for firms with high volatility and leverage than a standard distance to default (DD) measure and (ii) clearly outperforms the DD measure when used to predict corporate default or to explain variations in credit spreads.

Keywords: Structural Credit Risk Models; Bankruptcy Prediction; Risk-Neutral Pricing (search for similar items in EconPapers)
JEL-codes: G13 G32 G33 (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-fmk, nep-for and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:lvl:lacicr:1219

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