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Modelling default risk with occupation times

Author

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  • Makarov, R.
  • Metzler, A.
  • Ni, Z.

Abstract

This paper develops a semi-analytic pricing formula, easily implemented via quadrature, for a structural model based on occupation times that contains both the Merton and Black–Cox models as limiting cases. In the model liquidation is triggered as soon as the firm’s asset value has spent a prespecified amount of time below the default barrier. Surprisingly, we find that the value of the firm’s debt (i) need not be monotone in the length of the grace period and (ii) need not lie between the limiting Merton and Black–Cox values.

Suggested Citation

  • Makarov, R. & Metzler, A. & Ni, Z., 2015. "Modelling default risk with occupation times," Finance Research Letters, Elsevier, vol. 13(C), pages 54-65.
  • Handle: RePEc:eee:finlet:v:13:y:2015:i:c:p:54-65
    DOI: 10.1016/j.frl.2015.03.003
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    References listed on IDEAS

    as
    1. Galai, Dan & Raviv, Alon & Wiener, Zvi, 2007. "Liquidation triggers and the valuation of equity and debt," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3604-3620, December.
    2. 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 351-367, May.
    3. 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 449-470, May.
    4. Hooghiemstra, Gerard, 2002. "On explicit occupation time distributions for Brownian processes," Statistics & Probability Letters, Elsevier, vol. 56(4), pages 405-417, February.
    5. repec:wsi:jfexxx:v:01:y:2014:i:03:n:s2345768614500238 is not listed on IDEAS
    6. Yildirim, Yildiray, 2006. "Modeling default risk: A new structural approach," Finance Research Letters, Elsevier, vol. 3(3), pages 165-172, September.
    7. Broadie, Mark & Kaya, Özgür, 2007. "A Binomial Lattice Method for Pricing Corporate Debt and Modeling Chapter 11 Proceedings," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(02), pages 279-312, June.
    8. Mark Broadie & Mikhail Chernov & Suresh Sundaresan, 2007. "Optimal Debt and Equity Values in the Presence of Chapter 7 and Chapter 11," Journal of Finance, American Finance Association, vol. 62(3), pages 1341-1377, June.
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    Citations

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    Cited by:

    1. repec:wsi:ijtafx:v:20:y:2017:i:07:n:s0219024917500467 is not listed on IDEAS
    2. Roman N. Makarov, 2016. "Modeling liquidation risk with occupation times," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 3(04), pages 1-11, December.
    3. Guérin, Hélène & Renaud, Jean-François, 2017. "On the distribution of cumulative Parisian ruin," Insurance: Mathematics and Economics, Elsevier, vol. 73(C), pages 116-123.

    More about this item

    Keywords

    Occupation time; Credit risk; Merton model; Black–Cox model; Structural models;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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