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Risk-neutral and actual default probabilities with an endogenous bankruptcy jump-diffusion model

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Author Info
Olivier Le Courtois ()
François Quittard-Pinon ()
Abstract

This paper focuses on historical and risk-neutral default probabilities in a structural model, when the firm assets dynamics are modeled by a double exponential jump diffusion process. Relying on the Leland [(1994a) Journal of Finance, 49, 1213–1252; (1994b) Bond prices, yield spreads, and optimal capital structure with default risk. Working paper no. 240, IBER, University of California, Berkeley] or Leland and Toft [(1996) Journal of Finance, 51(3), 987–1019] endogenous structural approaches, as formalized by Hilberink and Rogers [(2002) Finance and Stochastics, 6(2), 237–263], this article gives a coherent construction of historical default probabilities. The risk-neutral world where evolve the firm assets, modeled by a class of geometric Lévy processes, is constructed based on the Esscher measure, yielding useful and new analytical relations between historical and risk-neutral probabilities. We do a complete numerical analysis of the predictions of our framework, and compare these predictions with actual data. In particular, this new framework displays an enhanced predictive power w.r.t. current Gaussian endogenous structural models. Copyright Springer Science+Business Media, LLC 2006

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Publisher Info
Article provided by Springer in its journal Asia-Pacific Financial Markets.

Volume (Year): 13 (2006)
Issue (Month): 1 (March)
Pages: 11-39
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Handle: RePEc:kap:apfinm:v:13:y:2006:i:1:p:11-39

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Related research
Keywords: Cumulative default probability; Structural model; Jump-diffusion; Endogenous capital structure; Esscher transform; Kou processes; G32; G33;

References listed on IDEAS
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  1. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 59-117, January. [Downloadable!] (restricted)
  2. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, vol. 6(2), pages 237-263. [Downloadable!] (restricted)
  3. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July. [Downloadable!] (restricted)
  4. Usabel, Miguel, 1999. "Calculating multivariate ruin probabilities via Gaver-Stehfest inversion technique," Insurance: Mathematics and Economics, Elsevier, vol. 25(2), pages 133-142, November. [Downloadable!] (restricted)
  5. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 12(4), pages 687-720.
  6. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(2), pages 481-523.
  7. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May. [Downloadable!] (restricted)
  8. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May. [Downloadable!] (restricted)
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  1. Olivier Le Courtois & François Quittard-Pinon, 2008. "The optimal capital structure of the firm with stable Lévy assets returns," Decisions in Economics and Finance, Springer, vol. 31(1), pages 51-72, May. [Downloadable!] (restricted)
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