Explaining CDS prices with Merton’s model before and after the Lehman default

Gordon Gemmill and Miriam Marra

Journal of Banking & Finance, 2019, vol. 106, issue C, 93-109

Abstract: We examine whether CDS prices around the Credit Crisis can be explained with Merton’s model. First we invert the model with market prices to reveal skewed volatility smiles over the whole 2005–2012 period. Then we calibrate the model to pre-Crisis data in two novel ways that allow for skewness, one based on equity-index options (MEIV) and the other on the sensitivity of CDS prices to equity volatility (MSKEW). In out-of-sample forecasts both calibrations match the in-Crisis peak of prices, but the second is better at capturing the systematic component of prices thereafter. Average CDS prices remain at twice their pre-Crisis level long after that event; the MSKEW calibration demonstrates that this is due to extra idiosyncratic risks, which are important for some firms but have negligible impact on others.

Keywords: Credit default swap; Merton’ model; Volatility smile; Credit crisis; Idiosyncratic risk (search for similar items in EconPapers)
JEL-codes: G1 G12 G19 (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:106:y:2019:i:c:p:93-109

DOI: 10.1016/j.jbankfin.2019.05.013

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