Default Risk in Stochastic Volatility Models

Hans Gersbach and Nicolae Surulescu ()
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Nicolae Surulescu: Institut für Angewandte Mathematik, Universität Heidelberg

No 10/131, CER-ETH Economics working paper series from CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich

Abstract: We consider a stochastic volatility model of the mean-reverting type to describe the evolution of a firm’s values instead of the classical approach by Merton with geometric Brownian motions. We develop an analytical expression for the default probability. Our simulation results indicate that the stochastic volatility model tends to predict higher default probabilities than the corresponding Merton model if a firm’s credit quality is not too low. Otherwise the stochastic volatility model predicts lower probabilities of default. The results may have implications for various financial applications.

Keywords: stochastic volatility; Merton model; default probabilities; rate of mean reversion (search for similar items in EconPapers)
JEL-codes: G13 G21 G32 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2010-06
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Citations: View citations in EconPapers (1)

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