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

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Author Info
Hayette Gatfaoui
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.

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Publisher Info
Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 123.

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Length: 40
Date of creation: 01 Apr 2004
Date of revision:
Publication status: Forthcoming in Greg N. Gregoriou Eds., Chapter 6, Advances in Risk Management, Palgrave-MacMillan, September 2006
Handle: RePEc:uts:rpaper:123

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Keywords: credit risk credit spread idiosyncratic risk stochastic voltility systematic risk

Find related papers by JEL classification:
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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  18. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November. [Downloadable!] (restricted)
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