Forecasting Default in the Face of Uncertainty

Abstract

Structural default models, starting with Merton, 1974, specify that default occurs when the value of the firm falls and hits a boundary that is a function of the firm's debt liabilities. This means that default probability, and therefore the credit spread on the firm's short-term debt, will be very close to zero when firm value is well above the barrier. But short-term spreads in the real world are not zero. In reduced-form models, default follows a random process that may hit at any time. This allows positive short-term spreads, but the cause of default is no longer modeled. In this article, Giesecke and Goldberg offer a hybrid approach, in which default occurs when firm value hits a barrier, but investors are uncertain about exactly where the barrier is. This is a very plausible assumption for real-world debt markets and it leads to a model with very plausible properties, including a connection between the value of the firm's assets relative to its debt obligations, and positive credit spreads even at the shortest maturities. Examples drawn from recent experience of several firms illustrate the differences between their model and earlier structural approaches.