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Merton's Model, Credit Risk, and Volatility Skews

by John Hull of the University of Toronto,
Izzy Nelken of Super Computer Consulting Incorporated, and
Alan White of the University of Toronto

Winter 2004/05

Abstract: In 1974 Robert Merton proposed a model for assessing the credit risk of a company by characterizing the company's equity as a call option on its assets. In this paper we propose a method for estimating the model's parameters from the implied volatilities of options on the company's equity. We use data from the credit default swap market to compare our implementation of Merton's model with the traditional approach to implementation.

Published in: Journal of Credit Risk, Vol. 1, No. 1, (Winter 2004/05), pp. 3-28.

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