Valuation models for default-risky securities: An overview

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.