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Credit Risk: Implementing Structural Models

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 Credit Risk: Implementing Structural Models

Victor Olofi Omomehin ([email protected])

African Institute for Mathematical Sciences (AIMS), Senegal
Supervised by: Prof. Tom Carroll
University College Cork, Cork, Ireland

February 8, 2021
Submitted in partial fulfilment of the requirements for the award of Master of Science in Mathematical Sciences at AIMS Senegal
DECLARATION
This work was carried out at AIMS Senegal in partial fulfilment of the requirements for a Master
of Science Degree.
I hereby declare that except where due acknowledgement is made, this work has never been
presented wholly or in part for the award of a degree at AIMS Senegal or any other University.

Student: Victor Olofi Omomehin

i
ACKNOWLEDGEMENTS
To Almighty God belongs the glory, thanks and praises.
I would like to express my sincere gratitude to my supervisor, Prof. Tom Carroll, who taught me
Computational Finance with Python and introduced me to the field of Credit Risk. I immensely
appreciate the time and efforts he directed toward the progress of my research. His guidance
was crucial to the development of this thesis, which would not have been the same without our
weekly meeting discussions. A very big thanks goes to my tutor, Dr. Mouhamad M. Allaya for
sharing some of his textbooks and organizing our weekly meetings on Skype.
I would also like to thank the African Institute for Mathematical Sciences (AIMS-Senegal) for
providing me with this scholarship and the opportunity to study alongside other bright-minded
fellow students from neighboring African countries. To my entire classmates (AIMS 2019-2021),
I wish you all the best in your endeavors.
Finally, I thank my mother and my siblings for their constant support and countless sacrifices.
Without them, I could never accomplish so much and reach this milestone in my life.

ii
DEDICATION
To the memory of my father, Mr Omomehin Abayomi.

iii
Abstract
Over the years creditors suffer losses due to failure on the part of borrowers to meet debt obli-
gations. It has become imperative to recognize and develop credit risk techniques to mitigate
the financial risks involved in lending. Lenders and investors access credit risk of individuals,
corporations, or government through credit risk modeling. In this thesis, we studied three major
structural credit risk models namely, the Merton, the Black and Cox, and the KMV model. In our
analysis, we utilized the Merton Model to analyze Apple company data. The analysis includes:
Computing the default probability of the company coupled with the estimation of the company’s
asset market value through the use of the Iterative procedure. Furthermore, we investigate the
relationship between the “actual” and “risk-neutral” probability of default. Our research findings
show that the risk-neutral probability of default serves as upper bound for the actual probability
of default.
Keywords: Credit risk, Merton model, Black and Cox model, KMV model, Actual default
probability (ADP), Risk-neutral default probability (RNDP), Expected default frequency (EDF),
Iterative procedure, Non-linear equations system, Capital Asset Pricing model (CAPM).

iv
Contents
Declaration i

Acknowledgements ii

Dedication iii

Abstract iv

1 Introduction 1
1.1 Aims and Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 What is Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2.1 Credit Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2.2 Credit Rating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2.3 Credit Default Swap (CDS) . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2.4 Factors affecting credit risk: . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2.5 Qualitative Credit Risk Models: . . . . . . . . . . . . . . . . . . . . . 5
1.2.6 Quantitative Credit Risk Models: . . . . . . . . . . . . . . . . . . . . . 5
1.3 Structural Credit Risk Models: . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.4 Reduced-form Credit Risk Model: . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.5 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 Literature Review 7
2.1 Drawbacks and Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

3 Methodology 10
3.1 Merton Model: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.1.1 Black-Scholes Option Pricing Framework . . . . . . . . . . . . . . . . . 11
3.1.2 Modeling the Actual Probability of Default (APD) . . . . . . . . . . . . 13
3.1.3 Risk Neutral Probability of Default . . . . . . . . . . . . . . . . . . . . 15
3.1.4 Credit spread implied by the Merton model . . . . . . . . . . . . . . . . 15

v
 3.1.5 Estimating Asset Value (At ) and Volatility (σA ) . . . . . . . . . . . . . 16
3.1.6 Nonlinear system of equations approach . . . . . . . . . . . . . . . . . . 16
3.1.7 Derivation of Asset and Equity Volatility Relation . . . . . . . . . . . . 16
3.2 Black and Cox Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3.2.1 Default Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3.2.2 Probability of Default . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3.2.3 Survival Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.3 Moody KMV model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3.1 Shifting from Merton Framework to KMV . . . . . . . . . . . . . . . . 21
3.3.2 Default Point (DP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3.3 Distance to Default (DD) . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.3.4 Expected Default Frequency (EDF) . . . . . . . . . . . . . . . . . . . . 22
3.3.5 Estimating Asset Value (At ) and Volatility (σA ) . . . . . . . . . . . . . 24
3.3.6 Iterative Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

4 Data Analysis 26
4.1 Data Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4.2 Data Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4.2.1 Iterative Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4.2.2 Capital Asset Pricing Model (CAPM) . . . . . . . . . . . . . . . . . . . 27
4.3 Results and Discussions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
4.3.1 Asset iterates (Market value) . . . . . . . . . . . . . . . . . . . . . . . 29
4.3.2 Annualized volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
4.3.3 Drift rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
4.3.4 Actual Probability of Default (APD) . . . . . . . . . . . . . . . . . . . 31
4.3.5 Risk-Neutral Versus Actual Default Probability . . . . . . . . . . . . . . 32

5 Conclusion 34

6 Appendix 35

References 39
1. Introduction
The term ”Credit” goes way back to ancient civilizations where creditors pay less attention to
credit risk. Default in one party (the debtor) often leads to quarrels and this breaks existing
relationships among families, kinsmen, friends, etc. In a bid to resolve this problem, many
measures were put in place, one of those was the one found in Hammurabi’s Code of law.
Hammurabi the Babylonian king who lived 4000 years ago wrote this code and outlined the basic
rule for borrowing. The code described failure to pay a debt as a crime and should be treated in
the same way as theft and fraud. The penalties for defaulting may include debtors being sold in
debt slavery while the debtor’s spouse and children would be forced into slavery (three-year term
of slavery). However, the code didn’t address concepts such as interest and collateral. These
concepts were spotted in some ancient religious books like the Bible and the Quran where stern
restrictions were issued to followers regarding how much interest to be charged on a loan.

During the Middle Ages, laws were also made specifically to deal with debtors. The law allows
creditors to drag debtors to court to obtain judgment against the debtor. This often resulted
in court seizing valuable things from the debtor’s home. Sometimes the debtor would be sent
to debtor’s jail until the debtor’s family could pay off the debt or until the creditor forgave it.
For the most part at various places and times in ancient history, credit default was a crime and
it was punishable by death, mutilation, torture, imprisonment, or enslavement and sometimes
punishments could also be extended to debtor’s dependents. For example, unpaid debts could
sometimes be transferred to relatives or political entities. Considering the potential consequences,
one may ask why would anyone borrow or lend money during ancient times. Borrowers risked hor-
rendous consequences from default, while lenders faced legal obstacles to collecting money owed.
Coming to the modern world, there have always been various financial risks faced by financial
institutions, banks, and other subjects. Various financial crises that have been experienced in the
past or recent times have shown how important it is to properly predict, estimate and recognize
risks. Risk management and prediction of potential losses are crucial factors in order to maintain
sustainability of business activities of institutions.

1.1 Aims and Objectives

The aims and objectives of this thesis are clear and stated as follows:

1. To understand credit risk from a practical point of view.

2. To study various credit risk models with their assumptions.
3. To implement the Merton model on Apple company’s stock data (AAPL).
4. To evaluate the unobserved market value of the firm’s assets using the Iterative procedure.
5. To model probability of default associated to a risky and non-risky asset.
6. To examine the relationship between the actual and the risk-neutral default probability.

1
Section 1.2. What is Credit Risk Page 2

1.2 What is Credit Risk

Credit risk is a measure of the creditworthiness of a borrower. In calculating credit risk, lenders
are gauging the likelihood they will recover all of their principal and interest. In other words,
lenders are judging borrowers’ ability to pay back debt when making a loan. Credit risk models
depend on many complex factors, thus the need to develop sophisticated credit risk rating models.
Over the years many credit risk models have been created in an attempt to measure the risk in
lending. These models fall into two broad categories, qualitative and quantitative. Before going
into qualitative and quantitative models, let’s first talk about some important terms in credit risk
such as Credit Spread, Credit Rating and Credit Default Swap.

1.2.1 Credit Spread

Credit spread can be defined in terms of a bond or option pricing. In the bond market, credit
spread is called yield spread and refers to the difference between two bonds’ yields that are the
same in all respects except their credit rating. The credit spread is a means of comparing the
creditworthiness of different borrowers in the capital markets. Credit spread in option pricing is
considered as a strategy constructed by selling an option and buying another option in the same
class at different strike prices with the same expiration.

Figure 1.1: Credit spread in option

Section 1.2. What is Credit Risk Page 3

1.2.2 Credit Rating

Credit rating simply determines the likelihood that the borrower will pay back a loan without
defaulting. Credit rating and Credit score are often used interchangeably in some cases but yet
are distinct. Credit score is assigned to an individual, and the score is a numeric value ranging
from 300 to 850. Credits ratings on the other hand are expressed in letter grade and they are
assigned to government and businesses. Letter grade can be investment grade (good rating) or
speculative grade (bad rating). Investment Grade represents high likelihood to meet payment
obligations while speculative grade indicates high risk of default. The table below presents types
of credit rating grade.

Figure 1.2: Credit Rating Scale

Image source : http://ctstatefinance.org/bonding /bondratings

Section 1.2. What is Credit Risk Page 4

1.2.3 Credit Default Swap (CDS)

A credit default swap is a financial derivative or some kind of insurance contract that allows the
transfer of credit risk from one party to another. In a CDS, one party “sells” risk and the counter
party “buys” the risks. The buyers of CDS are provided with protection against a specific risk and
in return the buyer has to agree to pay a periodic fee to the seller. On the other hand, the seller
of the CDS who has now taken the transferred risk of the buyer has to pay a certain promised
amount if a default should occur. For example, let’s assume that a bank grants a loan to a firm
and the bank isn’t sure if the firm will be able to repay the loan. The bank decides to buy a CDS
from a CDS seller in exchange for a protection which comes with compensation in the event that
the firm in question should default on their loan. This protection comes at a price in which the
buyer has to make series of payment to the CDS seller for accepting the transferred risk of the
firm who may default in the future.

1.2.4 Factors affecting credit risk:

Credit risk is affected by several factors such as the followings

• Default probability (PD):
This refers to the likelihood that a borrower will default on their loans over a particular
horizon and is obviously the most important part of a credit risk model. For individuals, this
score is based on their existing credit score and their debt-income ratio. For institutions that
issue bonds, this probability is determined by rating agencies like Moody’s and Standard &
Poor’s. The PD generally determines the interest rate and the amount of down payment
needed (collateral).

• Loss Given Default (LGD):

This refers to the total loss that the lender will suffer if the debt is not repaid. This is a
critical component in credit risk modeling. For instance, imagine two borrowers with same
credit scores and same debt-to-income ratios. The first borrower takes a $2,000 loan, and
the second borrows $200,000. Even if the second individual has 100 times the income of
the first, their loan represents a greater risk. This is because the lender stands to lose a
lot more money in the event of default on a $200,000 loan. Most lenders do not calculate
LGD for each separate loan; instead, they review an entire portfolio of loans and estimate
total exposure to loss. Several factors can influence LGD, including any collateral on the
loan and the legal ability to pursue the defaulted funds through bankruptcy proceedings.

• Exposure at Default (EAD):

In the event of a default, how large will the outstanding obligation be when the default
occurs? EDA answers this question by measuring total exposure that a lender is exposed to
at any given point of time. It is calculated by multiplying each loan by a certain percentage
depending on the particulars of the loan.
Section 1.3. Structural Credit Risk Models: Page 5

• Recovery Rate:
In the event of a default, the fraction of the exposure may be recovered through bankruptcy
proceedings or some other form of settlement.

1.2.5 Qualitative Credit Risk Models:

These were the earliest or first models used and involve getting information by asking lot of
questions before lending out money. Such models take into account certain factors such as
debt’s seniority, collaterals, nature of business, credit history, economic indicator (inflation) etc.
However, this model is subjective and depends on the lender’s personal judgment or experience
about whether a specific outcome is likely to occur. It does not involve any formal calculation.
The impact of subjectivity on this model led to the practice of “quantifying the qualitative” a
necessary step.

1.2.6 Quantitative Credit Risk Models:

The intuition behind quantitative credit risk models is to be able to assign some kind of credit
measure or comparable numbers to the likelihood of default risk. This allows lenders to make
decisions based on a chosen threshold whether this is the risk they would want to hold, transfer
or what interest rate to charge depending on default probability (low credit risk borrowers are
charged low interest rates). The main objective of these models is to provide ways to price and to
hedge financial contracts that are sensitive to credit risk. There are about five main types of credit
risk quantitative models: credit scoring models, structural models, reduced-form models, credit
migration models and credit portfolio models. However, in order to model the default process
and recovery rates two competing methodologies emerged, namely, the structural approach and
the reduced-form approach.

1.3 Structural Credit Risk Models:

Structural approaches are concerned with modeling and pricing credit risk that is specific to a
particular corporate obligor (a firm). The basic idea is that a company (with limited liability)
will default if the value of its assets is sufficiently low when compared to its liabilities. These
models require strong assumptions on the dynamics of the firm’s assets, its debt and how its
capital is structured meaning the probability of default for a firm is calculated based on the value
of the firm’s assets, equity and liabilities. The main advantage of structural models is that they
provide an intuitive picture, as well as an endogenous explanation for default. In other words,
the structural approach aims to provide an explicit relationship between default risk and capital
structure. The Merton model was the first structural model and has served as the cornerstone
for all other structural models such as the Black and Cox (1976) model with a flat barrier, the
Longstaff and Schwartz (1995) model with stochastic interest rates, the Collin-Dufresne and
Section 1.4. Reduced-form Credit Risk Model: Page 6

Goldstein (2001) model with a stationary leverage, and the double exponential jump diffusion
model used in Huang and Huang (2003).

1.4 Reduced-form Credit Risk Model:

In this approach, the value of the firm’s assets and its capital structure are not modeled at all, and
the credit events are specified in terms of some exogenously specified jump process (as a rule, the
recovery rates at default are also given exogenously). We can distinguish between the reduced-
form models that are only concerned with modeling of the default time called the intensity based
models, and the reduced-form models with migrations between credit rating classes, called the
credit migration models.
The main emphasis in the intensity-based approach is placed on modeling of random time of
default, as well as evaluating conditional expectations under risk-neutral probability functionals
of the default time and the corresponding cash flows. Typically, the random default time is
defined as the jump time of some one-jump process. A pivotal role in evaluating the respective
conditional expectations is played by the so-called default intensity process. Modeling of the
intensity process, which is also known as the hazard rate process, is the starting point in the
intensity approach.

1.5 Glossary
• Credit Event: a default, bankruptcy, or other situation which is recognized as affecting
the creditworthiness of a country or organization and which may trigger insurance payments
as defined in a credit default swap.

• Seniority: refers to the order of repayment in the event of a sale or bankruptcy of the
issuer.

• Collateral: This refers to the assets owned by a borrower that can be used to secure a
loan. The more collateral a borrower has, the lower the possible credit risk for a lender.

• Liquidation: is the method of putting an end to business and performing asset distribution
to those claiming any money from the company.

• Sovereign risk: is the risk of a government or central bank being unwilling or unable to
meet its contractual obligations.

• Debt-to-income ratio: This compares the amount a person makes against their living
expenses and debt payments. Lenders use it to decide if a borrower can afford to take on
a new debt payment.
2. Literature Review
The insight from the work of (Black and Scholes, 1973) and (Merton, 1974) shed more light on
credit pricing models and led to the birth of structural models. (Merton, 1974) being the first
of this kind paved the way for other structural models. (Jones et al., 1984) show how structural
models systematically underestimated observed spreads. Their research was carried out on a
sample of firms with simple capital structures observed during the year 1977 to 1981. (Ogden,
1987) confirmed this result by showing that the Merton model underpredicted spreads over U.S.
treasuries by an average of 104 basis points. (Delianedis and Geske, 2001) study the credit spread
proportion that is explained by default risk in a set of corporate bond data, using the (Merton,
1974) and (Geske, 1977) approach. They concluded that only a small fraction of credit spreads
are explained; the remainder is due to taxes, jumps, uncertainty, and market risk factors.
Moody’s KMV (Kealhofer, McQuown, and Vasicek), being a widely accepted commercial ap-
plication of structural models, extended Merton’s model by combining an empirical distribution
of distance-to-default with the Vasicek-Kealhofer (VK) model to generate the Expected Default
Frequency (EDF) (see Crosbie and Bohn (2003), Kealhofer (2003a), Kealhofer (2003b), and
Vasicek (1984)). (Bharath and Shumway, 2004) studied the accuracy of predicting default in
KMV model. The authors compare the KMV model accuracy with a simpler alternative. They
discovered that the implied default probabilities from credit default swaps and corporate bond
yield spreads are only weakly correlated with KMV-Merton default probabilities. The authors
concluded that the KMV-Merton model does not provide a sufficient statistic for default, which
can be obtained using relatively naı̈ve hazard models. (Hillegeist et al., 2004) and (Du et al.,
2004) compare the KMV model to other models and find that the KMV model does not provide
adequate predictive power.
First Passage models were introduced with the work of Black and Cox (1976). Black and Cox
(1976) modeled the default point as a time-dependent barrier. The default-risky coupon bonds
from Black and Cox is a natural extension of (Merton, 1974) with an endogenous default boundary.
(Fouque et al., 2006) studied the impact of introducing stochastic volatility into the First Passage
Model, their findings resulted in short-term spreads. (Bielecki and Rutkowski, 2002) generalized
the Black and Cox (1976) model to study the pricing of coupon bonds, optimal capital structure,
and other types of safety covenants.
(Hull et al., 2004) present an alternative approach for estimating the non-observable asset volatil-
ity. Considering the implied volatility of options on the company’s stocks, the authors propose
an approach different from the variance restriction method to measure asset volatility. The
method is based on the (Geske, 1979) model, which suggests that since the equity of a company
can be considered as an option on the firm’s assets, an option on the firm’s stock is a com-
pound option, and further provides a valuation formula for such a compound option. Using the
(Geske, 1979) formulation, the authors present a two-equation system that can be solved with
two implied volatilities, sampled from stock options. (Geske, 1977) views the liability claims as
compound options. Geske assumes that the firm is given the option of issuing new equity to ser-
vice debt. (Longstaff and Schwartz, 1995) incorporate stochastic interest rates into the structural
model thereby creating two-factor specifications. (Leland and Toft, 1996) consider the impact

7
Section 2.1. Drawbacks and Extensions Page 8

of bankruptcy cost and taxes on the performance of the structural model. They assume the
firm issues a constant amount of debt continuously with fixed maturity and continuous coupon
payments. (Collin-Dufresne and Goldstein, 2001) expand the Longstaff and Schwartz model by
adding a stationary leverage ratio, allowing firms to move away from their target leverage ratio in
the short run only. (Zhou, 1997) and (Hilberink and Rogers, 2002) worked with structural models
in which the firm’s asset value incorporates a jump component. Zhou also extends (Longstaff
and Schwartz, 1995) model considering a lognormal distributed jump component. (Hilberink and
Rogers, 2002) opt for an extension of (Leland and Toft, 1996) using Levy processes for downward
jumps in the firm’s value.

2.1 Drawbacks and Extensions

One problem with Merton’s model is the limitation of default time to the debt maturity, ruling
out the possibility of early default, regardless of what happens to the value of the firm prior to
the debt maturity. For instance, if the value of the company falls to a minimum level before the
debt maturity but later recovered to meet the payment of the debt at maturity, default would be
avoided in Merton’s approach. (Black and Cox, 1976) often referred to as the “first-pass-time
model ” was developed to fix the problem of “default at maturity” in Merton’s model. The model
was based on the fact that default may occur not only at maturity, but also before maturity, as
long as the asset value of the firm falls below the “pre-specified barrier” which is the default trigger
value. This allows defaults to occur throughout the lifetime of the reference debt or entity. Also,
there were some parameters in the Merton model that were assumed to be constant. (Longstaff,
1995) improve this shortcoming of Merton’s model by presenting the short-term risk-free interest
rate as a stochastic process that converges to a risk-free long-term interest rate and is negatively
correlated to the asset value process, so that the immediate impact of monetary policy on the
macro economy is considered.
Another disadvantage of Merton’s model is that a firm’s usual capital structure is far more
complicated than a simple zero-coupon bond. Geske (1977), Geske (1979) regards the company’s
debt structure as a coupon bond, where each coupon payment is considered as a compound option
and a possible default cause. At each coupon payment the shareholders have the option of either
making the payment to the bondholders, obtaining the right to control the company until the
next coupon, or not making the payment, in which case the company defaults. Geske also extends
the model to consider features such as sinking funds, safety covenants, debt subordination and
limitations on payouts. Another major criticism the Merton model has received is the assumption
of a constant and flat term structure of interest rates. (Jones et al., 1984) propose that “there
exists evidence that introducing stochastic interest rates, as well as taxes, would improve the
model’s performance.”
(Eom et al., 2003) conducted an empirical analysis of five models (Merton, Geske, Leland and
Toft, Longstaff and Schwartz, as well as Collin-Dufresne and Goldstein). They assume that the
asset risk premium is a stochastic process and it negatively correlated to the unexpected shock
to the return of asset value. They concluded that
Section 2.1. Drawbacks and Extensions Page 9

“Using estimates from the implementations we consider most realistic, we agree that
the five structural bond pricing models do not accurately price corporate bonds.
However, the difficulties are not limited to the under prediction of spreads. They all
share the same problem of inaccuracy, as each has a dramatic dispersion of predicted
spreads.”
3. Methodology
3.1 Merton Model:
Merton (1974), use Black and Scholes (1973) option pricing theory to model a firm’s capital
structure (equity and debt) relating it to credit risk on the assumption that default will be
triggered if the value of the assets fall below the value of its liabilities at maturity.

Consider a scenario:
Suppose that, at time t, At is the value of the company’s assets composed of the company’s
equity Et and debt Dt in the form of a zero-coupon bond with a face value L maturing at time
T > t. The capital structure is given by the accounting equation:

At = Et + Dt (3.1.1)

At time t = 0, the bond is sold at D0 on the market. The company must pay the value of L
to its creditors at time t = T (maturity). However, there is a possibility that the company may
default on its debt obligation if the value of the company (Assets) falls below its liabilities L at
maturity. In this scenario the company is liquidated and the assets are distributed in order of
seniority. It is assumed that debt takes precedence over equity, therefore, creditors are paid first
while the leftover value of the company is reserved for the equity holders.

Figure 3.1: Equity holders and Creditors Payoff.

10
Section 3.1. Merton Model: Page 11

From Figure 3.1 we observed the following possibilities :

• Equity holders:
If AT ≥ L then there is sufficient money to pay the liability L and equity holders received
what’s left in the amount of AT − L. However, if AT < L then there is not enough money
to pay the company’s liabilities hence the creditors keep what is left of the company while
the equity holders walk away with nothing. Thus,

ET = max{AT − L, 0} (3.1.2)

This is the payoff from a European call option on the company’s assets AT with strike
price L. Thus, the equity holders can be viewed as holding a call option on the value of the
company with strike price L.
• Creditors:
If AT ≥ L then the creditors receive full payment L. If AT < L then the creditors receive
the full value of the company which is less than L. Thus, the creditor get:

DT = min(AT , L) = L − max{L − AT , 0} (3.1.3)

This is equivalent to risk-free zero-coupon bond with face value L and a short put guaranteed
on the firm’s assets.

3.1.1 Black-Scholes Option Pricing Framework

We can now adapt the firm’s capital structure and the assumptions stated from the above to fit
the requirements of the Black-Scholes model. The fluctuation of asset value over time in the
market is assumed to take the form of a random walk (see figure 3.2 below). For this reason we
assume that the asset value follows a geometric Brownian motion process (GBM). The risk-neutral
dynamics is given by the stochastic differential equation:
dAt
= rdt + σA dWt , A0 > 0, (3.1.4)
At
where Wt is a standard Brownian motion, σA is the asset’s volatility, and r is the risk-free rate
of return. The solution to the above dynamic is achieved through Ito’s lemma:
Proof :

Let Ft = F (At ) = log At . From Ito’s lemma :

∂F (At ) ∂F (At ) 1 ∂ 2 F (At ) 2

dFt = ∂t dt + ∂At dAt + 2 ∂A2t (dAt )
Section 3.1. Merton Model: Page 12

∂F (At ) ∂F (At ) 1 ∂ 2 F (At)

∂t =0, ∂At = At , ∂A2t
= − A12
t

dAt 1 1
dFt = − (At σA )2 ( 2 )dt (3.1.5)
At 2 At
Substitute (3.1.4) into (3.1.5) we have:

dFt = (r − 12 σA2 )dt + σA dWt

On integrating both sides from 0 to t we obtain:

1
log At = log A0 + (r − σA2 )t + σA Wt (3.1.6)
2
so that,

1 2
At = A0 et(r− 2 σA )+σA Wt (3.1.7)

Based on the assumption of equation (3.1.2), we can now apply the Black-Scholes formula
(European call option) to compute the value of equity at time t (0 ≤ t ≤ T ) given as:

Et = At N (d1 ) − Le−r(T −t) N (d2 ) (3.1.8)

where:
 2

σA
At
ln( )+ r+ 2 (T −t)
L
d1 = √
σA T −t
 2

At σA
√ ln( L )+ r− 2 (T −t)
d2 = d1 − σA T − t = √
σA T −t

Et = Theoretical value of a company’s equity

At = Value of the company’s assets at time t
L = Face value of the company’s debt
t = Current time
T = Maturity date of the bond (the time to maturity is τ = T − t).
r = Risk-free interest rate.
N = Cumulative standard normal distribution.
σA = Asset volatility of the firm, assumed constant
Section 3.1. Merton Model: Page 13

3.1.2 Modeling the Actual Probability of Default (APD)

Here we are interested in deriving the actual probability of default at maturity T. We will start
with the assumption that the firm’s asset value follows a Geometric Brownian Motion :

dAt
= µdt + σA dWt , A0 > 0, (3.1.9)
At
where µ is the firm’s drift rate. Figure 3.2 gives a brief overview on the necessary assumptions
needed to compute the probability of default.

Figure 3.2: Probability of Default.

The probability of default is mathematically expressed as :

Pdef = P rob(AT ≤ L) (3.1.10)

where Pdef is the probability that the market value of the firm’s assets will be equal or below its
book value of liabilities at maturity. Assume the asset value is given as :

2
σA
(µ− 2 )t+σA Wt
At = A0 e (3.1.11)
Section 3.1. Merton Model: Page 14

σA
ln(At ) = ln(A0 ) + (µ − )t + σA Wt (3.1.12)
2
The asset value At is the solution to the asset dynamics in (3.1.9) obtained using Ito’s lemma.
Substituting (3.1.12) into (3.1.10) we obtained the expression:
  σA  
Pdef = P rob ln(A0 ) + µ − t + σA Wt ≤ ln(L) (3.1.13)
2
From the properties of Brownian motion we know that

W (t+T )−W (t)

εt+T = √
T
and εt+T ∼ N (0, 1)

√
Hence Wt = tε and we can therefore rewrite (3.1.13) as follows:
  σA  √ 
Pdef = P rob ln(A0 ) + µ − t + σA tε ≤ ln(L) (3.1.14)
2
!
A0 σA



ln L
+ µ− 2
t
Pdef = P rob − √ ≥ε (3.1.15)
σA t

Since ε ∼ N (0, 1), the corresponding probability of default in (3.1.15) is written in terms of
standard cumulative normal distribution where A0 is the current value of the asset.

A0

σA

!
ln L + µ− 2 t
Pdef = N − √ (3.1.16)
σA t

This can also be written as :

Pdef = N (−d) = 1 − N (d) (3.1.17)

where N (d) is the survival function and d is the distance-to-default,

A0 σA



ln L + µ− 2 t
d= √ (3.1.18)
σA t
Section 3.1. Merton Model: Page 15

3.1.3 Risk Neutral Probability of Default

As we have seen from the above, the method used to get the probability of default N (−d)
does not involve Black-Scholes-Merton (BSM) option pricing theory. Yet similar to the BSM’s
component N (d2 ) given below:

  2
 
At

σA
ln L + r − 2 (T − t)
N (d2 ) = N  √  (3.1.19)
σA T − t

If we reverse (3.1.19) to become N (−d2 ) we can use this refinement to estimate the probability
of default but this will be done under the assumption of the risk-neutral probability measure
where all assets are expected to grow at a risk-free rate (r). The probability of default associated
to N (−d2 ) is called the risk-neutral probability of default. Furthermore, under the physical
probability measure, the risk-free rate parameter r would be replaced by a real or physical firm
drift (µ) which implies the mean rate of return on the asset. The probability of default based
on the physical firm drift (µ) is called the actual probability of default N (−d). Note, the actual
probability of default was derived from a simple statistical procedure as shown in (3.1.10) to
(3.1.16). In summary, the key difference between the risk-neutral and the actual probability of
default is that the former uses risk-free rate parameter r while the later use a physical drift
parameter (µ) which can be computed by compounding the expected asset return from the
Capital Asset Pricing Model (CAPM).

3.1.4 Credit spread implied by the Merton model

Creditors are often exposed to default risk, they can hedge their position completely by purchasing
a European put option written on the same underlying asset At with strike price L. Such a put
option will worth L − AT if AT < L, and will be worth nothing if AT > L. Combining these
two positions (debt and put option), creditors will be guaranteed a payoff of L at time T, thus
forming a risk-free position:
Dt + Pt = Le−r(T −t) (3.1.20)
where Pt denotes the put option price at time t and it is estimated by applying the Black-Scholes
formula for a European put option:
Pt = Le−r(T −t) N (−d2 ) − At N (−d1 ) (3.1.21)
The corporate debt is a risky bond, and thus should be valued at a credit spread (risk premium).
Let s denote the continuously compounded credit spread, then the bond price Dt can be written
as:
Dt = Le−(r+s)(T −t) (3.1.22)
Putting (3.1.20), (3.1.21) and (3.1.22) together gives a closed-form formula for s:
1 At
s=− ln[N (d2 ) − er(T −t) N (−d1 )] (3.1.23)
T −t L
Section 3.1. Merton Model: Page 16

which allows us to solve for credit spread when asset level and return volatility (At and σA ) are
available for given t, T , L, and r .

3.1.5 Estimating Asset Value (At ) and Volatility (σA )

In order to compute the credit spread and the probability of default of a firm, one must first obtain
the asset value and the asset volatility. Unfortunately, these values are not directly observable
from the market. We can however find estimates for the firm’s asset value and its volatility using
any of the following approaches:

• Iterative approach.
• Nonlinear system of equations approach.

Here we will start with the Nonlinear system of equations approach and then discuss the Iterative
approach in the later section (Moody’s KMV section). These approaches require numerical
implementation.

3.1.6 Nonlinear system of equations approach

The equations below are characterized by two unknown variables which are the unobserved asset
value and its volatility. These equations are solved simultaneously for the value of At and σA .

Et = At N (d1 ) − Le−r(T −t) N (d2 ) (3.1.24)

At σA
σE = N (d1 ) (3.1.25)
Et

We are familiar with (3.1.24) from the Black-Scholes Merton framework. The equity-asset volatil-
ity relationship in (3.1.25) was derived from asset and equity dynamics using Ito’s lemma.

3.1.7 Derivation of Asset and Equity Volatility Relation

Now, let’s derive the asset and equity relation in (3.1.25). First, we assume that the firm’s asset
and equity follow a Geometric Brownian Motion expressed as the following stochastic differential
equations:

dAt = (µA At )dt + (σA At )dWt (3.1.26)

dEt = (µE Et )dt + (σE Et )dWt (3.1.27)

Section 3.1. Merton Model: Page 17

where
µE is the instantaneous “drift” of the equity price process.
σE is the instantaneous equity volatility
dWt is a Wiener process.

Suppose the equity of the firm is a function of asset (A) and time (t) written as Et = F (At , t).
Then a new dynamic can be found by applying Ito’s formula to the equity function and hence
the following:
From Ito’s lemma
1
dEt = dF = Ft dt + FAt dAt + FAt At (dAt )2 (3.1.28)
2
We substitute dAt from (3.1.26) into (3.1.28) we obtain :
 
1 2 2
dEt = Ft + FAt (µA At ) + FAt At (σA At ) dt + FAt (σA At ) dWt (3.1.29)
2

∂Et ∂Et ∂2F ∂ 2 Et

where Ft = ∂F
∂t = ∂t , F At = ∂F
∂At = ∂At , F At At = ∂A2t
= ∂A2t
.
Thus,

1 ∂ 2 Et 2 2
 
∂Et ∂Et ∂Et
dEt = + (µAt ) + 2
(σA At ) dt + (σA At )dWt (3.1.30)
∂t ∂At 2 ∂At ∂At

By comparing the coefficient of the Wiener processes (dWt ) in (3.1.27) and (3.1.30) we found
an important relation given by :
  
∂Et At At
σE = σA = σA ∆ (3.1.31)
∂At Et Et

∂Et
∆= ∂At , where ∆ is the hedge ratio, N (d1 ) from Black-Scholes.

At σA
σE = N (d1 ) (3.1.32)
Et

The application of this approach is easily illustrated through the following example.

Example 3.1.1. Assume the observable market capitalization of a public company is $50 million
and the calculated equity volatility of the company is 70.0 percent. Further, assume that the
company has issued a single zero-coupon bond with principal of $40 million that matures in two
years and the current risk-free interest rate is 2.0 percent (for purposes of the model, a flat term
structure is assumed).
Section 3.1. Merton Model: Page 18

We are interested in the value of the unknowns which are the unobserved value of the asset and
its volatility. We solved this problem using a numerical approach via Python implementation.
Solution

import numpy as np
import scipy.stats as st
import scipy.optimize as opt
from math import exp

debt = 40000000
equity = 50000000
equity_vol = 0.7
T = 2
rate = 0.02

# Initializing asset’s value and volatility

asset = equity + debt
asset_vol = round(equity_vol*(equity/asset),5)

def f(variables) :
(asset,asset_vol) = variables

d1 = (np.log(asset/debt)+(rate + T*(asset_vol**2)/2 ))/asset_vol*np.sqrt(T)

d2 = d1-asset_vol*np.sqrt(T)

# Equation 1
f1 = equity - asset*st.norm.cdf(d1,0,1)+debt*exp(-rate*T)*st.norm.cdf(d2,0,1)

# Equation 2
f2 = equity_vol - asset_vol*(asset/equity)*st.norm.cdf(d1,0,1)

solutions = [f1, f2]

return solutions

# Solver
result = opt.newton(f,(asset,asset_vol))

print(’Asset value = ’,round(result[0],3) ,’,’,’Volatility = ’,round( result[1],3))

Asset value = 88384003.659 , Volatility = 0.396

Using the above approach we obtained the implied current value of the firm assets At =
$88, 384, 003.66 and the implied asset volatility σA = 40%. The Newton optimizer used here
may not have yielded the best result. For instance, the Excel solver produces a better result
estimating the asset’s value and its volatility as At = $87, 138, 636 and σ = 42.2% respectively.
If we get our hands dirty with little parameter tuning, the Newton method might yield best result.
However, the goal of this illustration is to show how the nonlinear system of equations approach
works with python.
Section 3.2. Black and Cox Model Page 19

3.2 Black and Cox Model

Black and Cox (1976) extend Merton’s model by refining the idea of ”default at maturity” to
”early default”. This implies that each time a firm’s asset value goes below a certain time-
dependent barrier K(t), default is triggered. This time-dependent barrier is called the ”Safety
Covenant” and it provides the firm’s bondholders the right to force the firm to bankrupt if at
anytime the firm’s value reaches or goes below a certain pre-specified threshold K(t). Thus, the
default time is given by:
τ = inf{t > 0 : At < K(t)} (3.2.1)
Just as in the Merton model, this Simple First Passage model assumes that the asset value follows
a geometric Brownian motion and outstanding debt with face value L at maturity T.

3.2.1 Default Barrier

For a specified time dependent barrier K(t), the bondholders are always completely covered if
K(t) > L, which is certainly unrealistic. However, the consistent definition of default becomes
possible if KT ≤ L. One of many ways to specify the safety covenant is by choosing an increasing
time dependent barrier:

K(t) = L0 eγt , L0 ≤ Le−γT (3.2.2)

The inequality in (3.2.2) ensures that the safety covenants K(t) never exceeds the discounted
face value of the debt L.

3.2.2 Probability of Default

Under the risk neutral measure, the asset dynamic is assumed to follow a geometric Brownian
motion:

dAt
= rdt + σA dWt (3.2.3)
At
We solved this stochastic differential equation using Ito’s lemma in order to obtain the value of
the firm’s asset.

1 2
At = A0 et(r− 2 σA )+σA Wt (3.2.4)

The first passage time to the default barrier can now be reduced to the first passage time for
Brownian motion with drift.
1 2
{At < K(t)} = {A0 et(r− 2 σA )+σA Wt ≤ L0 eγt }
Section 3.2. Black and Cox Model Page 20

{At < K(t)} = {Wt + σA−1 (r − 12 σA2 − γ)t ≤ σA−1 log( AL00 )}

We define the risk neutral probability of default occurring before time t ≤ T as :

    
As −1 L0
Q[0 ≤ τ < t] = Q min( ) ≤ 1 = Q minXs ≤ σA log (3.2.5)
s≤t K(s) s≤t A0
 2
  
σA
where Xt = Wt + mt , m = σA−1 r− 2
−γ , d= σA−1 log L0
A0

This is a classic problem of probability. By reflection principle (see Musiela and Rutkowski (2006)
Part III APPENDIX) the solution is given as:

Q[0 ≤ τ < t] = 1 − F P (−d; −m, t) (3.2.6)

   
d − mt 2md −d − mt
F P (d; m, t) = N √ −e N √ ,d ≥ 0 (3.2.7)
t t

where Q[0 ≤ τ < t] is the probability of default occurring before time t ≤ T and τ is the default
time.

3.2.3 Survival Probability

The survival probability is given as :

   
−d + mt 2md d + mt
F P (−d; −m, t) = N √ −e N √ (3.2.8)
t t
This can also be written as:

F P (−d; −m, t) = N (h1) − h3[N (h2)] (3.2.9)

where    2

A0 σA
−d + mt log L0
+ r− 2
−γ t
h1 = √ = √ (3.2.10)
t σA t
   2

L0 σA
d + mt log A0
+ r− 2
−γ t
h2 = √ = √ (3.2.11)
t σA t

2a 2
σA
r− −γ

2md L0 2
h3 = e = , a= (3.2.12)
A0 σ
Section 3.3. Moody KMV model Page 21

3.3 Moody KMV model

KMV was found and introduced in the late 80’s by Kealhofer, McQuown, and Vasicek.The model
was acquired by Moody’s Corporation in 2002. Since the acquisition in 2002, the model has been
maintained and developed on a continuous basis by Moody’s Corporation. KMV, now Moody’s
KMV, is a structural model like the Merton model but with more realistic assumptions. This model
tries to overcome many weaknesses seen in the Merton model by introducing new concepts like
default point, multi-class liabilities, distance to default and Expected Default Frequency. We will
briefly explain each of these concepts by blending it into the Merton model framework.

3.3.1 Shifting from Merton Framework to KMV

One has to modify some few assumptions in the original Merton model in order to move from
the Merton framework to KMV’s. Here we outline the key points where KMV diverges from a
strict structural model.

Figure 3.3: Expected Default Frequency.

3.3.2 Default Point (DP)

All liabilities in the Merton model are mapped to zero coupon bonds, this assumption is replaced
with multiple class liabilities such as short term liabilities, long-term liabilities etc. In the KMV
model default may occur before maturity and it is triggered whenever the asset value goes below a
certain threshold called default point (DP). The default point of a firm is usually placed somewhere
between the short-term debt and half the long-term debt.
Section 3.3. Moody KMV model Page 22

1
DP = ST D + LT D (3.3.1)
2
The insight here is that the firm will always have to prioritize the short term debt over the long
term debt. Furthermore, default does not necessarily occur when the firm’s asset value reaches
the book value of their total liabilities. However, a firm will default when the difference between
firm’s assets and the firm’s default point reaches zero.

3.3.3 Distance to Default (DD)

The default point is an essential ingredient for computing the distance to default (DD) in the
KMV model. The DD is the number of standard deviations the asset value is away from default
point and it is calculated from the given relation below:
At − DP
DD = (3.3.2)
At σA

Recall from the Merton model, the 1-year probability of default is given as N (−d)
where 2
σA
log(At ) − log(L) + (µ − 2
)
d= (3.3.3)
σA
σ2
According to empirical research, the quantity µ − 2A is very close to zero hence negligible (see
Crosbie and Bohn, 2002). We approximate (3.3.3) to the expression below :

2
σA
log(At ) − log(L) + (µ − 2
) log(At ) − log(L) At − L
≈ ≈ . (3.3.4)
σA σA σA At

We then substitutes the liability L with the default point DP in KMV.

At − L At − DP
≈ . (3.3.5)
σA At σA At

At − DP
DD = . (3.3.6)
σA At

3.3.4 Expected Default Frequency (EDF)

The Expected Default Frequency is a fundamental quantity in the KMV model used for calculating
the probability that a given firm will default within a year. In the Merton model, the probability of
default is computed from a normal distribution and this does not conform to the true probability
compared to the KMV’s EDF computed from empirical data. The figure below displays some of
Section 3.3. Moody KMV model Page 23

the few relevant assumptions in the KMV model that differ from the Merton model.

Figure 3.4: Comparison of Assumptions

(a) Merton model (b) KMV model

The EDF of a firm is given by:

At − DP
EDFKM V = Femp (DD) = Femp ( ). (3.3.7)
σA At

We then replace the normal distribution function “N (.)” in the Merton model with a decreasing
empirical function “Femp (.)”. The figure below shows how this function works

Figure 3.5: Mapping from DD to EDF.

Section 3.3. Moody KMV model Page 24

The function F emp(.) maps the distance to default of a firm to the proportion of a huge historical
database of companies that have similar DD value that have defaulted in the past. This implies
that two different companies with the same DD will have the same EDF.

Example 3.3.1.
Current market value of assets A0 = 1, 000
Net expected growth of assets per annum µ = 20
Expected asset value in one year At = 1, 200
Annualized asset volatility σA = 100
Default point Dp = 800

1,200−800
distance to default, DD = 100
= 4.

Among the population of all the firms with DD = 4 at one point in time, say 5000 firms, 20
defaulted in one year. Then

20
EDF1−yr = 5000
= 0.004 = 40bp

Example 3.3.2. Federal Express (dollars in billions of US)

November 1997 February 1998

Market capitalization
$7.9 $7.3
(price × shares outstanding)
Book liabilities $4.7 $4.9
Market value of assets $12.6 $12.2
Asset volatility 15% 17%
Default point $3.4 $3.5

12.6−3.4 12.2−3.5
distance to default = 0.15×12.6
= 4.9 0.17×12.2
= 4.2

EDF = 0.06% (6bp) ≡ AA− 0.11% (11bp) ≡ A−

3.3.5 Estimating Asset Value (At ) and Volatility (σA )

We could simultaneously solve for the asset value and volatility using equity value and equity
volatility as shown in the previous section. But, Crosbie and Bohn (2003) state that a simulta-
neous solution for these equations yields poor results. Instead we will use an iterative approach
for optimum result of asset’s value and volatility.
Section 3.3. Moody KMV model Page 25

3.3.6 Iterative Approach

We will begin this approach by rearranging the Black-Scholes formula in (3.1.8), we get:

A = E + Le−r(T −t) N (d2 ) ÷ N (d1 )

 
(3.3.8)

If we go back in time, say 260 trading days, we obtain a system of equations:

 
−rt (T −t)
At = Et + Lt e [N (d2 )t ] ÷ N (d1 )t
 
−rt−1 (T −(t−1))
At−1 = Et−1 + Lt−1 e [N (d2 )t−1 ] ÷ N (d1 )t−1
..
.  
−rt−a (T −(t−a))
At−a = Et−a + Lt−a e [N (d2 )t−a ] ÷ N (d1 )t−a

Iteration 0 :

First, we start the procedure by initializing the asset value from the data using the accounting
equation:
At−a = Et−a + Lt−a , a = 0, 1, . . . , 260 (3.3.9)
where Lt−a and Et−a represent the liabilities and the equities from the time series data. The
equity is given as:

Equity = stock price × number of stocks

We then compute the log asset returns:

 
Asset Returns = ln At
At−1
, At = T oday 0 s price and At−1 = Y esterday 0 s price

Next, the standard deviation of asset returns is computed and use as the asset volatility σA .

Iteration k = 1, 2 ,.., end :

We compute new asset values and volatility by substituting previous asset values and volatility
into the rearranged system of Black-Scholes Merton equations seen from the above. This process
is repeated till the squared difference between two volatilities (σA ) from any two consecutive
iterations converged to 10−4 or till the sum squared difference between any two consecutive asset
iterations converges to 10−10 , this define the stopping criteria for the Iterative approach.
4. Data Analysis
4.1 Data Description
We begin by gathering daily historical data from two different data sources namely, yahoo finance
and Kenneth R. French data library. This data was taken from the same timeline and consists of
260 trading days records ranging from year 2019 to 2020.

Required data:
1. Apple’s stock price (equity) and assumed debt of Apple company (liability)
2. One month US government treasury bill (risk free rate)
(http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data library.html#Research)
3. Stocks market index (S&P 500)

These collections of daily historical data forms the core dataset needed for our analysis. In this
thesis, the S&P 500 is used to proxy the US stock market since it contains 500 most watched
stocks in the US stock market. Also, the one month US government treasury bill is used to proxy
the risk free rate knowing full well that even the most safest investment in the real world has
small amount of risk associated to it.

4.2 Data Implementation

4.2.1 Iterative Procedure
Calculating the value of company asset (Ak+1 ) and its annualized volatility (σA )
The unobserved market values of the asset and its volatility is essential for the estimation of
default probability. These parameters can be estimated endogenously using the iterative procedure
discussed in chapter three of this thesis. A quick review of this procedure is as follows:

(a) Firstly, we compute the book asset values using formula below :

Ai = Ei + Li , i = 0, 1, . . . , 260 (4.2.1)
(b) Next, we compute
 the
 log asset returns :
Ai
ri = ln , Ai = T oday 0 s price and Ai−1 = Y esterday 0 s price (4.2.2)
Ai−1

(c) Compute the historical volatility :

v
u n
uX 260
σA = t (ri − r), (4.2.3)
i=1
n − 1

where r is the mean return

26
Section 4.2. Data Implementation Page 27

(d) We compute new asset values Ak+1 by substituting the previous asset values Ak and its
annualized volatility σA into the formula below:

Ak+1 = E + Le−r(T −t) N (d2 ) ÷ N (d1 )

 
(4.2.4)

(e) Finally, step (b) to (d) is repeated many times till the sum squared difference error between
two consecutive asset iteration is close to zero.
X
SSD = (Ak − Ak+1 )2 ≤ 10−10 , k = 0, 1, . . . , n (4.2.5)
k represent the number of iterations.

4.2.2 Capital Asset Pricing Model (CAPM)

Calculating the annualized company’s drift rate, (µ)

Generally, Investors will expect a more risky asset to have greater rate of return. Many factors
go into models used in calculating risk-return trade-off of an asset when compared to the stock
market say S&P 500 index. The capital asset pricing model (CAPM) provides us with the
required factors needed to compute the expected return of an asset. This expected return is used
to compute the asset’s drift rate required for the estimation of the actual probability of default of
a firm. The CAPM of Sharpe (1964), Lintner (1965a,b), and Mossin (1966) is written as follow :

E[Ri ] = Rf + βi (E[Rm ] − Rf ) (4.2.6)

Ri = Return of stock i.
Rf = Risk-free rate.
Rm = Market return.
E[Rm ] − Rf = Average annualized market risk premium.
βi = Beta (a measure of systematic risk)

Cov(Ri , Rm )
βi = (4.2.7)
V ar(Rm )

The steps involved in calculating the drift rate are as follows:

1. First, we compute daily returns

Ai − Ai−1
Ri = , i = 0, 1, 2 . . . , 260 (4.2.8)
Ai−1
Section 4.3. Results and Discussions Page 28

2. We compute the excess returns

Excess returns = Ri − Rfi , i = 1, 2, . . . , 260 (4.2.9)

3. Compute the annualized market risk premium

M arket premium = E[Rm ] − Rf (4.2.10)

4. Compute the beta (β) and the expected returns using the formula in equation (4.2.7) and
(4.2.6) respectively.

5. We finally compute the drift rate

µ = ln(1 + E[Ri ])) (4.2.11)

4.3 Results and Discussions

In this section we discuss the results achieved from this study. The table below shows the result
obtained from applying the iterative procedures step (a) to (e).

Table 4.1: Using the iterative approach to estimate asset values and asset volatility

Date Equity Liabilities log risk Book Asset log Asset Asset
free rate Asset returns iterate iterate
(market log
value) returns

T E ($) L ($) Rf Ak ($) rK AK+1 ($) rK+1

2019-01-28 153.207 170.328 1.00% 323.535 321.357

2019-01-29 151.619 170.328 1.00% 321.947 -0.49% 319.748 -0.50%
2019-01-30 161.98 170.328 1.00% 332.308 3.17% 330.231 3.23%
2019-01-31 163.146 170.328 1.00% 333.475 0.35% 331.409 0.36%
. . . . . . .
. . . . . . .
. . . . . . .
2020-02-03 307.098 362.865 0.60% 669.963 -0.13% 666.443 -0.13%
2020-02-04 317.236 362.865 0.60% 680.101 1.50% 676.74 1.53%
2020-02-05 319.823 362.865 0.60% 682.688 0.38% 679.365 0.39%
2020-02-06 323.564 362.865 0.60% 686.429 0.55% 683.158 0.56%
The annualized asset volatility 0.32% 0.31%
Section 4.3. Results and Discussions Page 29

4.3.1 Asset iterates (Market value)

From Table 4.1 we have been able to estimate the unobserved market value of the asset as shown
in column Ak+1 . However, for the purpose of our analysis we are also interested in how the
iterations transpired. Table 4.2 provides us with all asset iterations from the iterative procedure.
Table 4.2: All iterations of asset

A0 A1 A2 A3 A4 A5 A6 A7
1 323.535232 321.283531 321.362182 321.356522 321.356958 321.356925 321.356927 321.356927
2 321.947265 319.672306 319.753397 319.747556 319.748006 319.747971 319.747974 319.747974
3 332.308120 330.169154 330.235492 330.230744 330.231109 330.231081 330.231084 330.231083
4 333.474547 331.348751 331.413593 331.408955 331.409313 331.409285 331.409287 331.409287
. . . . . . . . .
. . . . . . . . .
. . . . . . . . .
257 669.962764 666.252964 666.456470 666.441825 666.442952 666.442866 666.442872 666.442872
258 680.101162 676.566984 676.752859 676.739520 676.740548 676.740469 676.740475 676.740474
259 682.688045 679.195352 679.376957 679.363934 679.364937 679.364860 679.364866 679.364865
260 686.428981 682.994043 683.169631 683.157053 683.158022 683.157947 683.157953 683.157953

Each asset iteration in Table 4.2 has 260 data points representing the number of trading days
mentioned earlier in this chapter. The difference between column A0 and A1 is quite obvious.
However, as we progress further the difference between any two consecutive iterations seems
to draw closer to zero which implies similarity. Looking at the last two columns, we seem to
have reached convergence at iteration A6 . In order to ensure true convergence, the iteration is
extended to A7 . The similarity between column A6 and A7 signified convergence. Figure 4.1
shows a quick overview of the sum squared difference error calculated from each iteration.

Figure 4.1: Sum of Squared Difference Error

Section 4.3. Results and Discussions Page 30

4.3.2 Annualized volatility

In Table 4.1, we obtained the annualized historical volatility of the book asset and the asset
iterate given as 0.32% and 0.31% respectively. We noticed a slight drop of 0.01% which signifies
a small change in the movement of the book asset price in the market. The figure below shows
the annualized volatilities from each asset iteration. We noticed a sharp drop in the first iteration
and a steady level maintained from the 3rd iteration until the end. This shows that the annualized
volatility seems to have converged earlier starting from the 3rd iteration which appear to be faster
than the asset iterate whose convergence cost 7 iterations.

Figure 4.2: Annualized Volatility

4.3.3 Drift rate

We compute the expected return on the book asset and the asset iterate by comparing their
respective performance to the US stocks market using S&P 500 as a benchmark. Table 4.3 only
covers CAPM’s step (1) to (2).
Section 4.3. Results and Discussions Page 31

Table 4.3: Comparing the Book asset and the Asset Iterate to the Stock Market (S&P 500)
Assets ($) Returns (%) Excess Returns (%)
Risk free S&P Book Asset S&P Book Asset S&P Book Asset
Date
rate 500 Asset Iterate 500 Asset Iterate 500 Asset Iterate
2019-01-28 1.00% 2643.85 323.535 321.357
2019-01-29 1.00% 2640.00 321.947 319.748 -0.10% -0.49% -0.50% -1.10% -1.49% -1.50%
2019-01-30 1.00% 2681.05 332.308 330.231 1.60% 3.22% 3.28% 0.60% 2.22% 2.28%
2019-01-31 1.00% 2704.10 333.475 331.409 0.90% 0.35% 0.36% -0.10% -0.65% -0.64%
2019-02-01 1.00% 2706.53 333.553 331.488 0.10% 0.02% 0.02% -0.90% -0.98% -0.98%
. . . . . . . . . . .
. . . . . . . . . . .
. . . . . . . . . . .
2020-01-31 0.60% 3225.52 670.808 667.303 -1.80% -2.09% -2.13% -2.40% -2.69% -2.73%
2020-02-03 0.60% 3248.92 669.963 666.443 0.70% -0.13% -0.13% 0.10% -0.73% -0.73%
2020-02-04 0.60% 3297.59 680.101 676.740 1.50% 1.51% 1.55% 0.90% 0.91% 0.95%
2020-02-05 0.60% 3334.69 682.688 679.365 1.10% 0.38% 0.39% 0.50% -0.22% -0.21%
2020-02-06 0.60% 3345.78 686.429 683.158 0.30% 0.55% 0.56% -0.30% -0.05% -0.04%

In order to compute the drift rate of the book asset and the asset iterate we construct a new
table (Table 4.4) to show the results from implementing step (3) to (5) in the CAPM.

Table 4.4: Capital Asset Pricing Model’s Parameters at Maturity

Average
At maturity annualized Expected asset
Beta (βi ) Drift rate (µ)
(2020-02-06) market risk return (E[Ri ])
premium
1 Book asset 0.2686 0.180804 0.054573 0.053136
2 Asset iterate 0.2686 0.214220 0.063550 0.061612

4.3.4 Actual Probability of Default (APD)

Finally, we retrieved the drift rates from Table 4.4 and compute the actual probability of default
of the company’s book asset and asset iterate.

Table 4.5: Probability of Default Using Drift Rate (µ)

At maturity
Book asset Asset iterate
(2020-02-06)

1 Debt (LT ) 362.865 362.865

2 Asset (AT ) 686.429 683.158
3 Volatility (σA ) 0.32% 0.31%
4 Drift rate (µA ) 5.31 % 6.16%

Actual Probability
5 2.17% 1.99%
of default (AP D)
Section 4.3. Results and Discussions Page 32

As we can see from Table 4.5, the actual default probability is very low since the company has
more than enough money in assets to pay its liability at maturity. In this research, more emphasis
is placed on the asset iterate, reason being that its values are unobserved and are generated from
estimating the market value of the company’s asset through Iterative procedure.

4.3.5 Risk-Neutral Versus Actual Default Probability

Assuming the risk is taken out of the equation, it will be interesting to see how the default
probability plays out in the risk-neutral world. Table 4.6 shows the risk-neutral default probability
(RNPD) with the risk-free rate (Rf) replacing the physical drift rate (µ) at maturity.

Table 4.6: Probability of Default Using Risk-free Rate (Rf )

At maturity
Book asset Asset iterate
(2020-02-06)

1 Debt (LT ) 362.865 362.865

2 Asset (AT ) 686.429 683.158
3 Volatility (σA ) 0.32% 0.31%
4 Risk-free rate (Rf ) 0.60 % 0.60%

Risk-neutral probability
5 3.06% 2.85%
of default (RN P D)

In our study we have come to know that if we plot the graph of default probability (PD) against
an increasing drift rate while keeping all other parameters constant we will have the figure below.

Figure 4.3: Default Probability against Drift Rate

Section 4.3. Results and Discussions Page 33

From Figure 4.3, we observed that a higher drift rate will produce a lower default probability.
Coming back to Table 4.6, the risk-free rate of the asset iterate given as Rf = 0.60% is com-
paratively lower than the drift rate µ = 6.16% in Table 4.5. This explains why the actual default
probability (APD) from Table 4.5 is quite low in value when compared to the risk-neutral default
probability (RNPD) in Table 4.6. Thus, it makes sense to logically think that the RNPD is an
upper bound for the APD since investors generally expect returns greater than the risk-free rate
for holding a risky underlying asset. However, if the underlying asset drift at a risk-free rate then
APD will be equal to RNPD hence the following inequality is true

AP D ≤ RN P D. (4.3.1)
5. Conclusion
This thesis is aimed at implementing credit risk models in a real life context. We implement
the Merton model on Apple company data where the unobserved market value of the company‘s
assets is estimated using the Iterative procedure. The Iterative approach is a powerful technique
that adapts well to the market dynamics. This adaptation served as an added advantage over
the non-linear equations system approach.
In our analysis, the iterative approach achieved convergence in the 7th iteration. The iterated
market value of the company asset is used to compute the actual probability of default (APD)
at maturity. The resulting probability of default of the company was estimated to be 1.99% and
this implies that the company has enough money in asset ($ 683) to pay its obligated debt in the
amount of $ 363.
Also, another analysis was conducted on the firm’s data but this time we replace the drift rate
(µ) with the risk free rate (Rf ) while keeping all other parameters constant. The risk-neutral
default probability (RNPD) estimated from this replacement was found to have overestimated the
company probability of default by difference of 0.86%. The inverse proportionality relationship
shown in Figure 4.3 explains why the default probability associated to the “risk-neutral” will
be greater than the “actual” since the risk-free rate used in computing the RNPD will always
be lower compared to the drift rate (µ) because investors will always charge a rate larger than
risk-free rate for holding a risky asset. Therefore the inequality below is true.

AP D ≤ RN P D.

34
6. Appendix
The Python code used for the analysis in chapter four of this thesis can be found in my GitHub
page. Please follow the link below:
https://github.com/omomehinvictor/Credit-Risk

35
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