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On the Valuation and Analysis of Risky Debt: A Theoretical Approach Using a Multivariate Extension of the Merton Model

Author

Listed:
  • Edwin O. Fischer
  • Lisa-Maria Kampl
  • Ines Woeckl

Abstract

This paper is concerned with the valuation and analysis of default-risky debt instruments with arbitrary interest and principal payments. For the valuation, we use three nested multivariate extensions of the standard Merton (1974) model for pricing risky zero-coupon bonds. First, we present a valuation framework for pricing single risky debt instruments with arbitrary interest and principal payments. We then extend this framework to enable the valuation of multiple debt instruments issued by the same firm. Finally, we further extend the model to additionally take continuous dividend payments to the equity holders into account. Based on these debt valuation frameworks, we calculate various key figures for the analysis of risky debt from the point of view of risk-neutral and risk-averse investors (e.g., promised and expected yields, default probabilities, recovery rates, distance to default, and expected payments).

Suggested Citation

  • Edwin O. Fischer & Lisa-Maria Kampl & Ines Woeckl, 2023. "On the Valuation and Analysis of Risky Debt: A Theoretical Approach Using a Multivariate Extension of the Merton Model," Credit and Capital Markets – Kredit und Kapital, Duncker & Humblot, Berlin, vol. 56(2), pages 197-232.
    • Handle: RePEc:dah:aeqccm:v56_y2023_i2_q2_p197-232
    DOI: 10.3790/ccm.56.2.197
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    More about this item

    Keywords

    risky debt valuation; Merton Model;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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