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A New Structural Approach to the Default Risk of Companies

by Pouyan Mashayekh Ahangarani of the University of Southern California

June 2007

Abstract: The Merton model, which is used for modeling default probabilities, is based on the assumption that the equity value is an option on the asset of a company with the strike price equal to the company debts. In the Merton model, it is implicitly assumed that debts last for a fixed period of time, and determining the default point that is the strike price of the option has been controversial in the literature. In this paper, a new model is proposed that borrows the equity price determinant from the asset pricing literature where equity price is equal to present value of the expected dividends. The dividends should be paid from the asset surplus, which is the asset value minus the debts. Ultimately, the model will be proposed in which the parameters of asset surplus can be estimated from the equity prices without using the default point information. The empirical results show that the new model proposed in this paper has more information relative to the Merton model in explaining the default probabilities when the leverage of the company is fed to the model.

Keywords: Merton Model, Credit Risk.

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