Structural Default Modeling: A Lattice-Based Approach

Abstract

That the stockholders’ right to default on corporate debt is an option has been understood since Merton’s seminal 1974 article. Later work by Geske and others applied Merton’s insight to more complex, and more realistic, capital structures and default criteria. Unfortunately, while it is not too hard to write down valuation equations for a firm with multiple classes of risky debt, the equations typically involve high-order multivariate normal distributions, which are quite difficult to evaluate computationally. In this article, Jabbour, Kramin, and Young propose a lattice model in which the default risk in complex capital structures becomes easier to deal with. One key to their approach is to build survival probabilities directly into the tree.

TOPICS: Derivatives, analysis of individual factors/risk premia, counterparty risk