Chapter 4

Structural Models of Credit Risk

Broadly speaking, credit risk concerns the possibility of financial losses due to changes in
the credit quality of market participants. The most radical change in credit quality is a
default event. Operationally, for medium to large cap firms, default is normally triggered
by a failure of the firm to meet its debt servicing obligations, which usually quickly leads
to bankruptcy proceedings, such as Chapter 11 in the U.S. Thus default is considered
a rare and singular event after which the firm ceases to operate as a viable concern,
and which results in large financial losses to some security holders. With some flexible
thinking, this view of credit risk also extends to sovereign bonds issued by countries with
a non-negligible risk of default, such as those of developing countries.
Under structural models, a default event is deemed to occur for a firm when its assets
reach a sufficiently low level compared to its liabilities. These models require strong
assumptions on the dynamics of the firm’s asset, its debt and how its capital is structured.
The main advantage of structural models is that they provide an intuitive picture, as well
as an endogenous explanation for default. We will discuss other advantages and some of
their disadvantages in what follows.

4.1 The Merton Model (1974)

The Merton model takes an overly simple debt structure, and assumes that the total value
At of a firm’s assets follows a geometric Brownian motion under the physical measure

dAt = µAt dt + σAt dWt , A0 > 0, (4.1)

where µ is the mean rate of return on the assets and σ is the asset volatility. We also
need further assumptions: there are no bankruptcy charges, meaning the liquidation value
equals the firm value; the debt and equity are frictionless tradeable assets.
Large and medium cap firms are funded by shares (“equity”) and bonds (“debt”). The
Merton model assumes that debt consists of a single outstanding bond with face value K
and maturity T . At maturity, if the total value of the assets is greater than the debt, the
latter is paid in full and the remainder is distributed among shareholders. However, if

41
42 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

AT < K then default is deemed to occur: the bondholders exercise a debt covenant giving
them the right to liquidate the firm and receive the liquidation value (equal to the total
firm value since there are no bankruptcy costs) in lieu of the debt. Shareholders receive
nothing in this case, but by the principle of limited liability are not required to inject any
additional funds to pay for the debt.
From these simple observations, we see that shareholders have a cash flow at T equal
to
(AT − K)+ ,
and so equity can be viewed as a European call option on the firm’s assets. On the other
hand, the bondholder receives min(AT , K). Moreover, the physical probability of default
at time T , measured at time t, is
Pt [τ = T ] = Pt [AT ≤ K] = N [−dP2 ]
√
where dP2 = (σ T − t)−1 (log(At /K) + (µ − σ 2 /2)(T − t)).
The value Et at earlier times t < T can be derived using the classic martingale ar-
gument (see exercise 24 for an alternative derivation). Assuming one can trade the firm
value At , we note that e−rt At is a martingale under the risk-neutral measure Q with
market price of risk φ = (µ − r)/σ and Radon-Nikodym derivative
! "
dQ 1 2
= exp φWT − φ T . (4.2)
dP 2
Then we find the standard Black-Scholes call option formula
Et = E Q [e−r(T −t) (AT − K)+ ] = BSCall(At , K, r, σ, T − t)
(4.3)
−r(T −t)
= At N [d1 ] − e KN [d2 ] (4.4)
where
log(At /K) + (r + σ 2 /2)(T − t) log(At /K) + (r − σ 2 /2)(T − t)
d1 = √ , d2 = √ (4.5)
σ T −t σ T −t
Bond holders, on the other hand, receive
min(K, AT ) = AT − (AT − K)+ = K − (K − AT )+ .
Therefore the value Dt for the debt at earlier times t < T can be obtained as the value of
a zero-coupon bond minus a European put option. Of course the fundamental identity of
accounting holds:
At = Et + Dt ,
and all three assets are discounted risk neutral martingales. A zero coupon defaultable
bond with face value 1 and maturity T will have the price P̄t (T ) = Dt /K, and has the
yield spread
! "
1 Ke−r(T −t) 1 r(T −t) At
Y St (T ) = log =− log e (1 − N [d1 ]) + N [d2 ]. (4.6)
T −t Dt T −t K
4.1. THE MERTON MODEL (1974) 43

Despite being derived from a debt structured with a single maturity T , this equation
is often interpreted as giving a function of T : it is imagined that if an additional bond of
small face value with a different maturity were issued by the firm, it would also be priced
according to (4.6). The qualitative behaviour of this term structure is that credit spreads
start at zero for T = 0, increase sharply to a maximum, and then decrease either to zero
at large times if r − σ 2 /2 ≤ 0 or a positive value if r − σ 2 /2 > 0. This is in accordance
with the diffusive character of the model. For very short maturity times, the asset price
diffusion will almost surely never cross the default barrier. The probability density of
default then increases for longer maturities but starts to decrease again as the geometric
Brownian motion drifts away from the barrier.
This behaviour is also observed in first passage and excursion models, except that
spreads exhibit a faster decrease for longer maturities. It is at odds with empirical obser-
vations in two respects: (i) observed spreads remain positive even for small time horizons
and (ii) tend to increase as the time horizon increases. The first feature follows from the
fact that there is always a small probability of immediate default. The second is a conse-
quence of greater uncertainty for longer time horizons. One of the main reasons to study
reduced-form models is that, as we will see, they can easily avoid such discrepancies.
The previously obtained formula for the physical default probability (that is under the
measure P ) can be used to calculate risk neutral default probability provided we replace
µ by r. Thus one finds that
# √ $
Q[τ > T ] = N N −1 (P [τ > T ]) − φ T .

and as long as φ > 0 we see that market implied (i.e. risk neutral) survival probabilities
are always less than historical ones.
In the event of default, the bondholder receives only a fraction AT /K, called the
recovery fraction, of the bond principal K: the fractional loss (K − AT )/K is called the
loss given default or LGD. As you will see in an exercise, the probability distribution of
LGD can be computed explicitly in the Merton model.
Note that equity value increases with the firm’s volatility (since its payoff is con-
vex in the underlier), so shareholders are generally inclined to press for riskier positions
to be taken by their managers. The opposite is true for bondholders. So-called “agency
problems” relate to the contradictory aims of shareholders, bondholders and other “stake-
holders”.
Structural models like Merton’s model depend on the unobserved variable At . On the
other hand, for publicly traded companies, the share price (and hence the total equity)
is closely observed in the market. The usual “ad-hoc” approach to obtaining an estimate
for the firm’s asset values At and volatility σ in Merton’s model uses the Black-Scholes
formula for a call option, that is,

Et = BSCall(At , K, r, σ, T − t), (4.7)

where K and T are determined by the firm’s debt structure. One combines this with a
second equation by equating the equity volatility to the coefficient of the Brownian term
44 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

obtained by applying Itô’s formula to (4.7), namely,

∂BSCall
σAt = σ E Et . (4.8)
∂A
As we will see in Section 4.3, a consistent method is to use Duan’s maximum likelihood
result [5] to estimate σ and µ directly from the equity time series E i . Once an estimate
for σ is obtained in this way, it can be inserted back into the pricing formula (4.7) in
order to produce estimates for the firm values Ai .
The Merton model is only a starting point for studying credit risk, and is obviously
far from realistic:
• The non-stationary structure of the debt that leads to the termination of operations
on a fixed date, and default can only happen on that date. Geske [10] extended the
Merton model to the case of bonds of different maturities.

• It is incorrect to assume that the firm value is tradeable. In fact, the firm value and
its parameters is not even directly observed.

• Interest rates should certainly be taken to be stochastic: this is not a serious draw-
back, and its generalization was included in Merton’s original paper.

• The short end of the yield spread curve in calibrated versions of the Merton model
typically remains essentially zero for months, in strong contradiction with observa-
tions.
The so-called first passage models extend the Merton framework by allowing default to
happen at intermediate times.

4.2 Black-Cox model

The simplest first passage model again takes a firm with asset value given by (4.1) and
outstanding debt with face value K at maturity T . However, instead of admitting only
the possibility of default at maturity time T , Black and Cox (1976) [3] postulated that
default occurs at the first time that the firm’s asset value drops below a certain time-
dependent barrier K(t). This can be explained by the right of bondholders to exercise
a “safety covenant” that allows them to liquidate the firm if at any time its value drops
below the specified threshold K(t). Thus, the default time is given by

τ = inf{t > 0 : At < K(t)} (4.9)

For the choice of the time dependent barrier, observe that if K(t) > K then bond-
holders are always completely covered, which is certainly unrealistic. On the other hand,
one should clearly have KT ≤ K for a consistent definition of default. One natu-
ral, but certainly not the only, choice is to take an increasing time-dependent barrier
K(t) = K0 ekt , K0 ≤ Ke−kT .
4.2. BLACK-COX MODEL 45

The first passage time to the default barrier can now be reduced to the first passage
time for Brownian motion with drift. Observing that
{At < K(t)} = {Wt + σ −1 (r − σ 2 /2 − k)t ≤ σ −1 log(K0 /A0 )},
we obtain that the risk neutral probability of default occurring before time t ≤ T is then
given by
% & % ! "&
−1 K0
Q[0 ≤ τ < t] = Q min(As /K(s)) ≤ 1} = Q min Xs ≤ σ log (4.10)
s≤t s≤t A0
where Xt = Wt + mt, m = σ −1 (r − σ 2 /2 − k). This is a classic problem of probability we
discuss in Appendix A, whose solution is given by
Q[min Xt ≤ d] = 1 − FP(−d; −m, t)
s≤t
% & % &
d − mt 2md −d − mt
FP(d; m, t) := N √ −e N √ , d≥0 (4.11)
t t
Thus we obtain the formula
Q[0 ≤ τ < t] = 1 − FP(−d; −m, t) (4.12)
with m = σ −1 (r − σ 2 /2 − k) and d = σ −1 log(K0 /A0 ) < 0.
The pay-off for equity holders at maturity is
(AT − K)+ 1{mins≤T Xs >d} = (ekT A0 eσXT − K)+ 1{mins≤T Xs >d} . (4.13)
This is equivalent to the payoff of a down-and-out call option, and can be priced by
“Black-Scholes”-type closed form expressions found for example in (Merton 74) [24]. The
equity in the Black-Cox model is smaller than the share value obtained in the Merton
model, and is not monotone in the volatility.
In the event of default, the pay-off for debt holders is Aτ = K(τ ) at the time of
default, and the fair “recovery value” can be computed by integrating K(s), discounted,
with respect to the risk-neutral PDF for the time of default. The value of the bond at
time t prior to default is a sum Dt = Dtb + Dtm of the recovery value and the value of the
payment at maturity. The recovery value is thus
' T
b
Dt = er(t−s) K(s)(−∂s FP(−dt ; −m, s − t))ds (4.14)
t
−1
where dt = σ log(K(t)/At ). The remaining term can be written
Dtm = E Q [e−r(T −t) [AT − (AT − K)+ ]1{τ >T } |Ft ]
which is a difference of barrier call options (one with zero strike). Computation of these
integrals can be done explicitly, as you will be asked to do in an exercise.
One can go further with the Black-Cox model and consider what happens if an addi-
tional bond is issued with face value $1 (considered to be negligible), and maturity T1 < T .
In the event τ ≤ T1 the bond would pay the “recovery fraction” R(τ ) := K(τ )/K, while
in the event τ ≥ T1 the bond pays the principal at maturity.
46 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

4.3 Time-Changed Brownian Motion Models

The intractable nature of first passage problems for processes beyond Brownian motion
has impeded efforts to extend the Black-Cox picture in the way that the Black-Scholes
equity model has been generalized to stochastic volatility and jump-diffusion models.
Hurd [14] has introduced one flexible way to extend to much more general processes.
The mathematical ingredients are a Brownian motion Wt , t ≥ 0 and an independent
“time change” process Gt , t ≥ 0. A time change is any non-decreasing
(t process with
G0 = 0. Examples are Poisson processes, processes of the form 0 λs ds with λs ≥ 0,
and Lévy subordinators (non-decreasing processes with independent increments and in-
finitely divisible transition densities). Then one defines the log-leverage process to be
Xt = log[At /K(t)] = x0 + σWGt + βσ 2 Gt .
The standard way to define the time of default would be
τ = inf{t ≥ 0|Xt ≤ 0}
but the first passage problem can no longer be solved explicitly. [14] instead proposes an
alternative definition
τ = inf{t ≥ 0|Gt ≥ τBM }, τBM = inf{t ≥ 0|x0 + σWt + βσ 2 t ≤ 0}
With this definition, one finds tractable formulas for all quantities of interest, starting
with the survival probability:
P [τ > t] = E[P [τ > t|G]] = E[FP(x0 /σ; βσ, Gt )] (4.15)
Note the use of iterated conditioning over the sigma-algebra G generated by the time
change G.
Here are two classes of time-changes that can easily be studied.
1. G is taken to be a Lévy subordinator [4], which are defined to be independent
increment, increasing pure-jump processes. A good example is the drifting gamma
process, in which case X will be a so-called variance-gamma process.
(t
2. Gt = 0 λs ds for some positive process λ. A good example is to take λ to be a CIR
process (3.36).

4.4 KMV
KMV1 is the name given to a particularly successful practical implementation of structural
credit modeling. It is instructive to see what assumptions they make in order to produce
commercially acceptable credit methods. The main difficulty, as in all structural models,
is in assigning dynamics to the firm value, which is an unobserved process. We outline the
main points, including the key point where KMV diverges from a strict structural model.
The firm KMV is named after Kealhofer, McQuown and Vasicek, the founders of the company in
1

2002. It has since been sold to Moody’s.

4.4. KMV 47

• Default trigger: The question is to determine a level for K from the structure of a
firm’s debt (which in practise consists of bond issues of different maturity, coupon
rate, seniority and features such as convertibility). In a nutshell, KMV puts the
value somewhere between the face value of short term debt, and the face value of
the total debt, arguing that the firm will always have to service short term debt,
but can be more flexible in servicing the long term debt. Typically, the trigger is
given by the full short term debt plus half the long term debt.

• Value of firm: Rather than try to estimate the firm value directly from detailed
balance sheet data (a procedure highly sensitive to assumptions and method) KMV
infers At from the value of debt (which is taken from balance sheet) and equity.

• Equity: KMV takes the safest course, defining it to be the market capitalization
(current share value times the number of shares outstanding). Since Et is observed
in the market, it is used to infer the value of At using the Black-Scholes call option
formula:
Et = BSCall(At , T − t, r, σ, K) (4.16)
The maturity date T is not so clear, but should represent the approximate time
scale of the debt2 .

• Calibration: The appropriate way to estimate model parameters and the firm value
process, given a time series {Êt1 , . . . , ÊtN } of market capitalization observed at times
ti = i∆t, i = 1, . . . , N is to use Duan’s theorem [5]. One finds that

(σ̂, µ̂) = arg max LE (Êt1 , . . . , ÊtN ; σ, µ)

σ,µ

and
Âti = Fi−1 (Êti , σ̂)
where Ei = Fi (A, σ) denotes the function BSCall. Here the log-likelihood function
is

LE (Êt1 , . . . , ÊtN ; σ, µ) = LA (F1−1 (Êt1 ), . . . , FN−1 (ÊtN ); σ, µ)

)N % &
∂Fi
− log (Fi−1 (Eti , σ))
i=1
∂A

where LA (At1 , . . . , AtN ; σ, µ) is the explicit log-likelihood function of the jointly log-
normal variables At1 , . . . , AtN . Thus from a time series of equity data, the method
leads to a time series Âti and an estimate σ̂, µ̂. Of course, even if the model were
true, if the estimate σ̂ is far from the true σ, the inferred time series  would differ
systematically from the “true” values of A.
2
For example, one could take it to be the duration of the debt.
48 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

From the data on a given date, KMV computes the key credit score DDt for the firm
at that time, called distance to default. Roughly speaking it gives the amount by which
log At exceeds log K measured in standard deviations σ of the one year PDF log At+1 .
That is
log(At /K)
DDt = (4.17)
σ
By a strict structural interpretation, EDF, the expected default frequency, meaning
the probability of observing the firm to default within one year, ought to equal the normal
probability EDFt = N (DDt ). KMV, however, breaks the model at this point, and instead
relies on its large database of historical defaults to map DD to EDF by a proprietary
function EDF = f (DD). f (DD) is designed to give the actual fraction of all firms with
the given DD that have been observed to default within one year.
Studies such as Duffie et al [6] indicate that the distance to default DDt is a reasonable
firm-specific dynamic (defined by current observations of the firm) quantity that correlates
strongly with credit spreads and observed historical default frequency.

4.5 Optimal Capital Structure Models

Papers by Leland and Toft [21, 22] use the Black-Cox framework to explore the question
of how a firm best capitalizes itself. They proposed that the owners of the firm will choose
to issue debt in the way that maximizes their equity. Two important control parameters
are the level of the default trigger K and the overall size of the debt. They consider two
factors, namely τ ≥ 0 the fractional tax benefit paid on debt coupons to the debt issuer,
and α ≥ 0, the bankruptcy costs as a fraction of firm value.

Assumption 4.

1. The firm’s asset value process At follows geometric Brownian motion:

dAt
= (r − δ)dt + σdWtQ (4.18)
At
for a constant risk-free rate r and “dividend rate” δ ≥ 0.

2. The debt is issued as a “perpetual bond” that pays constant coupon rate C per unit
of time;

3. The debt contract specifies a level K such that the firm defaults at any time that
At ≤ K. That is, the time of bankruptcy is

τB = inf{t|At ≤ K} (4.19)

4. A tax rebate is paid at the rate τ C on debt coupons, for some constant τ ∈ [0, 1);
4.5. OPTIMAL CAPITAL STRUCTURE MODELS 49

5. At the time of default, the equity is zero, and the debt is valued at (1 − α)K for
some fraction α ∈ [0, 1). That is, bankruptcy charges of αK are paid at the time
τB .

The picture to have is that at some time (take this to be t = 0), the owners of the
debt-free firm with value A0 decide to “raise capital” by issuing debt in the form of a
perpetual bond that pays a constant coupon rate C and confers on the bondholders the
right to put the firm in default when the firm value falls below K. By doing this, the
owners hope to increase the value of their equity by some amount. The question then is:
Question: What values (C ∗ , K ∗ ) maximize the equity E at time t = 0?

Using risk neutral valuation leads to the value of the issued debt at time 0
' τB
Q −rτB
D0 = E [e (1 − α)K1{0≤τB <∞} ] + E [Q
Ce−rt dt] := D(A0 ; K, C) (4.20)
0

The value of the firm after recapitalization will be

' τB
v0 = A + E [ Q
τ Ce−rt dt] − E Q [e−rτB αK1{0≤τB <∞} ] := v(A0 ; K, C) (4.21)
0

Finally, one can show directly that the firm equity will be
' τB
E0 = v0 − D0 = E [ Q
(δAt − (1 − τ )C)e−rt dt] (4.22)
0

It turns out that all the above valuation formulas can be expressed in terms of the
Laplace transform L(α, b, µ) = Φτb (α) for τb = inf{t|Wt + µt ≥ b}, which is given by
(A.34) : √
µ2 +2α)
Φτb (α) := E[e−ατb ] = eb(µ−
First we note that At = exp[log A0 + σWt + (r − δ − 12 σ 2 )t]. Changing the sign of the
Brownian motion in the usual way converts the lower crossing problem into an upper
crossing problem, and one can see that the first term of (4.20) equals
! "−γ
A0
(1 − α)KL(r, d0 , −m) = (1 − α)K
K
√
where d0 = σ1 log(A0 /K), m = σ1 (r − δ − 12 σ 2 ) and γ := σ1 (m + m2 + 2r). The second
term of (4.20) becomes

C C
E Q [ (1 − e−rτB )1{0≤τB <∞} + 1{τB =∞} ]
r r * ! "−γ +
C C A0
= [1 − L(r, d0 , −m)] = 1− (4.23)
r r K
50 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

Similarly, * ! "−γ + ! "−γ

Cτ A0 A0
v 0 = A0 + 1− − αK
r K K
Finally, when A0 > K we have
* ! "−γ + ! "−γ
(1 − τ )C A0 A0
E0 = v0 − D0 = A0 − 1− −K
r K K

while E0 = 0 when A0 ≤ K.
One can now address the big question as follows
(1−τ )C
1. Fix C, and find the value K ∗ (C) < r
so that the “smooth pasting condition”

dE
|A=K = 0
dA
holds. K ∗ (C) is the optimal K for this value of C.

2. Plug this value of K into the formula for E, and maximize over C to find C ∗ and
K ∗ = K ∗ (C ∗ ).
γ(1−τ )C
The solution in step 1 is easily seen to be K ∗ (C) = (γ+1)r
. The solution for C ∗ is
! "−1/γ
∗ r(1 + γ) (1 + γ)τ + α(1 − τ )γ
C = A0 (4.24)
γ(1 − τ ) τ

4.6 Default Events and Bond Prices

We have learned from structural models, particularly the Black-Cox model, that two
factors are critical in determining the value of defaultable bonds, namely the probability
of default (PD) and the loss given default (LGD). In this section we explore some general
properties of the probability of default, and see what these imply for defaultable bonds.
Recall that the default time τ is a stopping time, that is, a random variable τ : Ω →
R+ ∪ {∞} such that {τ ≤ t} ∈ Ft , for every t ≥ 0. In other words, a random time τ is a
stopping time if the cádlág3 stochastic process
,
1, if τ (ω) ≤ t
Ht (ω) = 1{τ ≤t} (ω) = (4.25)
0, otherwise

is adapted to the filtration Ft . For default times, Ht is known as the default indicator
process, and Htc = 1 − Ht is the survival indicator process.
3
for “continueux á droite, limite á gauche”, or “right continuous, left limit”.
4.6. DEFAULT EVENTS AND BOND PRICES 51

We say that a stopping time τ > 0 is predictable if there is an announcing sequence of

stopping times τ1 ≤ τ2 ≤ · · · such that

lim τn = τ, P-a.s
n→∞

If you have studied stochastic analysis you will recognize this as the statement that the
indicator process Ht is predictable. For the record, the opposite of a predictable stopping
time is a totally inaccessible stopping time, that is, a stopping time τ such that

P [τ = τ̂ < ∞] = 0,

for any predictable stopping time τ̂ . It can be shown that every stopping time can be
expressed as the minimum of a predictable and a totally inaccessible stopping time.
Example 2. For any adapted process Xt , we may define stopping times τd = inf{t|Xt ≥
d}. If X is an Itô diffusion (and therefore has continuous paths a.s.), this is a predictable
stopping time: one takes any sequence {dn }∞ n=1 that increases to d, and then {τdn } is an
announcing sequence. Conversely, if Xt is a pure jump process (for example a Poisson
process), then τd is totally inaccessible.

4.6.1 Unconditional default probability

Given a default time τ , the probability of survival in t years is

P [τ > t] = 1 − P [τ ≤ t] = 1 − E[1{τ ≤t} ]. (4.26)

Several other related quantities can be derived from this basic probability. For instance,

P [s < τ ≤ t] = P [τ > s] − P [τ > t]

is the unconditional probability of default occurring in the time interval [s, t].
Using Bayes’s rule for conditional probability, one can deduce that the probability of
survival in t years conditioned on survival up to s ≤ t years is
P [{τ > t} ∩{ τ > s}] P [τ > t]
P [τ > t|τ > s] = = , (4.27)
P [τ > s] P [τ > s]

since {τ > t} ⊂ {τ > s}. From this we can define the forward default probability for the
interval [s, t] as

P [τ > t]
P [s ≤ τ ≤ t|τ > s] = 1 − P [τ > t|τ > s] = 1 − . (4.28)
P [τ > s]

Assuming that P [τ > t] is strictly positive and differentiable in t, we define the forward
default rate function as
∂ log P [τ > t]
h(t) = − . (4.29)
∂t
52 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

It then follows that Rt

P [τ > t|τ > s] = e− s h(u)du
. (4.30)
The forward default rate measures the instantaneous rate of arrival for a default event
at time t conditioned on survival up to t. Indeed, if h(t) is continuous we find that for a
short time interval [t, t + ∆t],
h(t)∆t ≈ P [t ≤ τ ≤ t + ∆t|τ > t].

4.6.2 Conditional default probability

The above probabilities are all derived from P [τ > t], that is, conditionally on the constant
information set available at time 0. More generally, one can focus on SPs (t) := P [τ >
t|Fs ], that is, the survival probability in t years conditioned on all the information available
at time s ≤ t. If we assume positivity and differentiability in t, then this can be written
as Rt
SPs (t) = Hsc e− s hs (u)du , (4.31)
where
∂ log SPs (t)
hs (t) = − . (4.32)
∂t
We define hs (t) to be the forward default rate process given all the information up to time
s: it clearly has the initial values h0 (t) = h(t).
The indicator process Ht defined in (4.25) is a submartingale. Moreover, since H can
be shown to be of class D, it follows from the Doob-Meyer decomposition4 that there
exists a unique nondecreasing predictable process Λt , called the compensator, such that
Ht − Λt is a uniformly integrable martingale. Since defaults happen only once, in general
we know that
Λt = Λτ ∧t .
In some cases the compensator can be written as
' t
Λt = λs ds (4.33)
0

for a non-negative, progressively measurable process λt . In this case the process λt is

called the default intensity. In other cases, such as Black-Cox models, the compensator
does not admit a default intensity (intuitively, the instantaneous probability of default is
either 0 or ∞).
Under suitable technical conditions it can be shown that
λt = ht (t). (4.34)
Therefore, while the forward default rate function h(t) gives the instantaneous rate of
default conditioned only on survival up to t, the default intensity λt measures the instan-
taneous rate of default conditioned on all the information available up to time t.
4
Please see [26] for a fundamental discussion of such matters.
4.7. EXERCISES 53

Finally, we observe that starting from a sufficiently regular family of survival probabil-
ities one can obtain forward default rates by (4.32) and the associated intensity by (4.34).
This is analogous to knowing a differentiable system of bond prices and then obtaining
forward and spot interest rates from it. As we have seen, going in the opposite direction,
that is from the spot interest rt to bond prices, is not always straightforward, and the
same is true for going from intensities to survival probabilities.

4.6.3 Implied Survival Probabilities and Credit Spreads

We now investigate how the prices of defaultable zero-coupon bonds can be used to infer
risk-neutral default probabilities. As we will see later, PD and LGD become entangled in
the bond pricing formula, and for that reason we will assume in this section that bonds
pay nothing in the event of default (“zero-recovery”). We also assume in this section that
interest rates rt and the default time τ are independent under the risk-neutral measure Q.
Let P̄t (T )1{τ >t} be the price at time t ≤ T of a defaultable zero-coupon bond issued
by a certain firm with maturity T and face value equal to one unit of currency. Then,
since we assume bonds pay zero recovery, we know that
- RT .
P̄t (T )1{τ >t} = EtQ e− t rs ds 1{τ >T } (4.35)

and since rt and τ are independent this becomes

P̄t (T )1{τ >t} = Pt (T )Q[τ > T |Ft ].

Therefore, as long as τ > t the risk-neutral survival probability is given by

' T
P̄t (T )
Q[τ > T |Ft ] = = exp[− (f¯t (s) − ft (s))ds] (4.36)
Pt (T ) t

Comparing with the definition of the yield spread Y St (T ) and the forward default rate
ht (T ), we see that
' T
1
Y St (T ) = ht (s)ds, ht (s) = f¯t (s) − ft (s).
T −t t
Thus the term structure of risk-neutral survival probabilities is completely determined
by the term structure of both defaultable and default-free zero-coupon bonds. In what
follows, even though the interpretation relies on the above two assumptions, (4.36) will be
called the implied survival probability, emphasizing the fact that it is derived from market
prices and associated to the risk-neutral measure Q.

4.7 Exercises
In the following exercises, we take the asset value process with parameters µ = r = 0.05
and σ = 0.20.
54 CHAPTER 4. STRUCTURAL MODELS OF CREDIT RISK

Exercise 22. The leverage ratio or debt/equity ratio of a firm is defined to be the total
debt of the firm divided by the equity Lt = Dt /Et . A highly leveraged firm has a lot
of debt which might indicate a danger of default, and certainly a susceptibility to rising
interest rates.

1. Consider the Merton model with the above parameters. Use MATLAB or similar
to plot the value of the debt D0 as a function of debt maturity T for the following
leverage levels: 10, 3, 1, 1/3, 1/10. (Hint: W.L.O.G. you may set K = 1. Then you
will need to use a root finding method (e.g. Newton-Raphson) to find the value of
A0 for a given level of leverage.)

2. Thinking of D0 (T ) as the price of a zero coupon defaultable bond, compute the

credit spread (defaultable bond yield minus default free bond yield) as a function
over T , again for the same leverage levels.

Exercise 23. (Alternative derivation of the Merton model) Suppose dAt = At [µdt +
σdWt ] under the physical measure, plus the other assumptions of the Merton model.
Suppose further that debt and equity are tradeable assets that satisfy At = Dt + Et and
follow processes Dt = D(t, At ), Et = E(t, At ) for differentiable functions. By considering
a locally risk-free self-financing portfolio of bonds and equity (which by necessity will
earn the risk-free rate of return), prove directly that both D, E satisfy the Black-Scholes
equation
1
∂t f + σ 2 A2 ∂A2 f + rA∂A f − rf = 0
2
Exercise 24. In the Merton model with the number of shares N constant, the stock price
is St = Et /N . Find a formula for the stock volatility as a function of time to maturity
(S)
and current equity, i.e. σt = f (T − t, St ). Find the stochastic differential equation for
St under the risk-neutral measure. Is St Markovian? Compute the asymptotics of stock
volatility when the leverage ratio tends to ∞. What does this say about the behaviour of
the stock price?

Exercise 25. For any s < T , compute the conditional probability density function
pτ (t|Fs ), t > s for the time to default τ in the Black-Cox model. What is the behaviour
of pτ as t → s+? Does this model have a default intensity?

Exercise 26. Loss given default LGD is defined to be the fraction of the bond principal
that is not returned to the bondholder at default. Compute the probability distribution
of LGD in the Merton model. Plot the pdf with T = 5 for the leverage levels 100, 30, 10,
3, 1, and compute the mean and standard deviation in each case.