Idiosyncratic Risk, Systematic Risk and Stochastic Volatility: An Implementation of Merton's Credit Risk Valuation

Hayette Gatfaoui

No 123, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: We extend the credit risk valuation framework introduced by Gatfaoui (2003) to stochastic volatility models. We state a general setting for valuing risky debt in the light of systematic risk and idiosyncratic risk, which are known to affect each risky asset in the financial market. The option nature of corporate debt allows then to account for the well-known volatility smile along with two documented determinants, namely stochastic volatility and market risk. Under some regularity conditions, we specify diffusion functionals leading to an asymptotically (relative to time) mean reverting volatility process. The behavior of such a specification is studied along with simulation tehniques since debt is valued via a call on the firm assets value. Specifically, our examination resorts to Monte Carlo accelerators to realize related simulations. First, we consider the evolution of stochastic volatility for given parameter values. Then, we assess its impact on both risky debt and the related credit spread.

Keywords: credit risk; credit spread; idiosyncratic risk; stochastic voltility; systematic risk (search for similar items in EconPapers)
JEL-codes: G13 G33 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2004-04-01
New Economics Papers: this item is included in nep-fin
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Published as: Gatfaoui, H., 2006, "Idiosyncratic Risk, Systematic Risk and Stochastic Volatility: An Implementation of Merton's Credit Risk Valuation", In Greg N. Gregoriou Eds., Chapter 6, Advances in Risk Management, Palgrave-MacMillan.

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Related works:
Working Paper: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility: An Implementation of Merton's Credit Risk Valuation (2006)
Working Paper: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility: An Implementation of Merton’s Credit Risk Valuation (2004)
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