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Model Implied Credit Spreads

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  • Gunnar Grass
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    Abstract

    I propose a new measure of credit risk, model implied credit spreads (MICS), which can be extracted from any structural credit risk model in which debt values are a function of asset risk and the payout ratio. I implement MICS assuming a barrier option framework nesting the Merton (1974) model of capital structure. MICS are the increase in the payout to creditors necessary to offset the impact of an increase in asset variance on the option value of debt. Endogenizing asset payouts, my measure (i) predicts higher credit risk for safe firms and lower credit risk for firms with high volatility and leverage than a standard distance to default (DD) measure and (ii) clearly outperforms the DD measure when used to predict corporate default or to explain variations in credit spreads.

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    File URL: http://www.cirpee.org/fileadmin/documents/Cahiers_2012/CIRPEE12-19.pdf
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    Bibliographic Info

    Paper provided by CIRPEE in its series Cahiers de recherche with number 1219.

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    Date of creation: 2012
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    Handle: RePEc:lvl:lacicr:1219

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    Related research

    Keywords: Structural Credit Risk Models; Bankruptcy Prediction; Risk-Neutral Pricing;

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    1. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04.
    2. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
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