Towards a “market continuum”? Structural models and interaction between credit and equity markets

F. Haas

Financial Stability Review, 2003, issue 2, 75-93

Abstract: The theory of the firm developed by Merton in the 1970s shows how the two financing instruments used by firms, i.e. equity and debt may be viewed as options on the value of their assets. Thus, a shareholder may be regarded as a holder of a call option on the firm’s assets, while a lender may be seen as a seller of a put option on these same assets. So-called structural models derived from this theory have been developed in recent years. They formalise the relationship between equity and debt, and more specifically, endeavour to assess the credit risk attached to each individual issuer on the basis of accounting data, such as its level of debt, and equity market data, such as volatility and stock prices. This article aims to describe these models and analyse the effect of the use of these models on capital markets from the perspective of financial stability. By fostering interactions between asset classes, their increased use has opened up the different market segments and, ultimately, has contributed to the creation of a market continuum. This type of quantitative analysis is thus likely to improve the way financial asset prices are formed, making relative asset prices more coherent and homogeneous. Developing models based on this approach is nevertheless a complex task and the relevance of this whole approach may be called into question if it gives rise to oversimplification or excessive confidence in the signals produced by such models. Structural models add to the spectrum of instruments for credit risk analysis at market participants’ disposal, but are not intended to replace them.

Date: 2003
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