Credit Risk Model with Lagged Information

Abstract

In a structural credit risk model, the credit spread is a function of how far firm value is above the critical level that will cause the firm to default. Previous research has shown that in a theoretical model with periodic information releases, such as quarterly earnings reports, the credit spread will exhibit a cyclical pattern and will tend to be much narrower immediately after a release than is observed empirically. Choi demonstrates that simply allowing information about the firm value to reach the market with a lag is enough to produce reasonable spreads without discrete information releases. Thus, is it the lag rather than the discreteness of announcements that keeps the credit spread at empirically observed levels?

TOPICS: Credit default swaps, credit risk management, simulations