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Valuation models for default-risky securities: An overview

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  • Saikat Nandi

Abstract

Valuing financial securities often assumes that the contractual obligations of the security are going to be honored. However, frequently a party to a contract will default on its obligations. Because the contractual features of defaultable securities are usually complex and it is difficult to find comparable securities for which to observe prices, valuation requires formal models that take into account the security's complexities and the uncertainties surrounding future cash flows. Many financial institutions hold large amounts of these securities in their portfolios, and it is important that these institutions have a reliable estimate of the resulting credit exposure. Understanding the strengths and drawbacks of various modeling approaches is also important for implementing prudent risk-management policies to manage credit exposures. ; The author of this article reviews developments in valuation models for defaultable securities dating back to Merton (1974), concluding that although researchers have improved considerably on the basic Merton framework, problems remain. For example, many of the institutional features of bankruptcy and defaults, such as rescheduling of debts, cannot be readily incorporated in the models discussed without making the models intractable. He points out the need for the next generation of valuation models to incorporate at least some institutional features and be able to use the historical probabilities of defaults and credit rating changes without making unnecessarily strong assumptions.

Suggested Citation

  • Saikat Nandi, 1998. "Valuation models for default-risky securities: An overview," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 22-35.
  • Handle: RePEc:fip:fedaer:y:1998:i:q4:p:22-35:n:v.83no.4
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    Citations

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    Cited by:

    1. Maclachlan, Iain C, 2007. "An empirical study of corporate bond pricing with unobserved capital structure dynamics," MPRA Paper 28416, University Library of Munich, Germany.
    2. repec:eee:pacfin:v:44:y:2017:i:c:p:47-63 is not listed on IDEAS
    3. repec:wsi:ijtafx:v:08:y:2005:i:06:n:s0219024905003256 is not listed on IDEAS
    4. Alejandro Revéiz Hérault, "undated". "Factores determinantes de los márgenes entre bonos del gobierno y bonos corporativos en los Estados Unidos," Lecturas en Finanzas 002710, Banco de la Republica de Colombia.
    5. Alexandros Benos & George Papanastasopoulos, 2005. "Extending the Merton Model: A Hybrid Approach to Assessing Credit Quality," Finance 0505020, University Library of Munich, Germany, revised 18 Nov 2005.
    6. M. Tudela & G. Young, 2005. "A Merton-Model Approach To Assessing The Default Risk Of Uk Public Companies," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(06), pages 737-761.
    7. Alley, David Christopher, 2004. "Corporate hedging and the cost of debt," ISU General Staff Papers 2004010108000017648, Iowa State University, Department of Economics.
    8. Papanastasopoulos, George, 2005. "Using Option Theory and Fundamentals to Assessing Default Risk of Listed Firms," MPRA Paper 453, University Library of Munich, Germany, revised Jun 2006.

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