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Wei, David Guoming and Dajiang Guo, "Pricing Risky Debt: An Empirical Comparison of the Longstaff and Schwartz and Merton Models", Journal of Fixed Income, Vol. 7, No. 2, (September 1997), pp. 828. Partial Introduction: The purpose of this article is to study the applicability and performance of two models for pricing corporate contingent liabilities: the models of Longstaff and Schwartz [1995] and Merton [1974]. Through empirical comparisons using Eurodollar data, we also highlight the behavior of the default risk premium in the Eurodollar market.
Corporate debt usually has finite lives and prespecified terminal values. There are two major types of risk: interest rate risk and default risk (credit risk). These two types of risk and their interaction are fundamental determinants in the valuing of corporate debt and its derivatives. {...} Different treatments of these two elements, together with the interaction of default risk and interest rate risk, have been the focus of various studies. Merton [1974] explicitly values pure discount bonds subject to default risk. He assumes that a firm has only one class of pure discount bond, and that firm value follows a diffusion process. Default may happen only at the maturity date of risky debt. If the firm value is less than the promised payments of debt at the maturity date, bondholders take over the firm immediately. {...} Longstaff and Schwartz [1995] combine many distinctive features of these studies in a single model. Like Merton [1974], they assume that firm value follows a diffusion process. As in Black and Cox [1976], they allow early default before the maturity date of a risky debt. Default happens when the firm value process reaches a constant safety threshold level from above. As in Kim, Ramaswamy, and Sundaresan [1987][REF], the riskless interest rate is assumed to follow a Vasicek [1977] process, and to be correlated with the firm value process. In this case, risky bond prices can be solved through an iterative method. An important finding is that the effect of a firm's correlation with interest rate changes cab be very significant in determining the value of its debt. JEL Classifications: N01, N10.
