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| Randomized Merton Model on Credit Spreads by Chuang Yi of McMaster University, and January 2008 Abstract: We propose to randomize the initial condition of a generalized Merton (1974), where the solvency ratio instead of the asset value is modeled explicitly. This randomization of the initial value is due to imperfect observation assumption on the underlying process. We find that positive short spreads can be produced due to imperfect observations on the risk factor. The Probability of Default (PD) and Loss Given Default (LGD) have explicit expressions which both are found to approach zero with an order of square-root of the maturity T, as T → +0. We therefore provide an example that has no well-defined default intensity but still admits positive short spreads. Our simple four-parameter set up is easy to be implemented and calibrated to the market data. This is illustrated by a calibration exercise on Ford Corp. CDS data. Keywords: Incomplete Information, Solvency Ratio, Short Spreads, Term Structure of Credit Spreads, Probability of Default, Loss Given Default. Download paper (251K PDF) 24 pages Previously titled: A Simple Model of Credit Spreads with Incomplete Information --and before that-- Credit Spreads Modeling: Randomized Merton Model
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