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Credit Risk Modeling under Conditional Volatility

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  • Rohde, Johannes
  • Sibbertsen, Philipp

Abstract

The accuracy of measuring credit risk directly decides on the interest on credit, which has to be paid when raising a credit, and the amount of capital to keep in reserve by a firm. The structural credit risk model proposed by Merton (1974) lays the groundwork for the assessment of a firm's credit risk by its default probability. Doubtlessly, the volatility of the firm's equity represents the most sensitive parameter influencing the default probability. By combining the Merton approach with conditional volatility models, we empirically examine in this article that the specification of conditional volatility affects the probability of default and therefor the credit rating. More precisely, we show on German stock market data that financial market data properties (i.e. asymmetric response of conditional volatility to return shocks and long-range dependencies within the conditional volatility) may not be neglected within the computation of credit risk. Moreover, the influence on the default probability by the type of conditional distribution is pointed out.

Suggested Citation

  • Rohde, Johannes & Sibbertsen, Philipp, 2014. "Credit Risk Modeling under Conditional Volatility," Hannover Economic Papers (HEP) dp-528, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    • Handle: RePEc:han:dpaper:dp-528
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    References listed on IDEAS

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    More about this item

    Keywords

    Credit risk; Merton model; conditional volatility; default probability; stylized facts;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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