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Modeling Default Risk: A new structural approach

by Yildiray Yildirim of Syracuse University

April 27, 2006

Abstract: This paper provides an alternative approach to the structural credit risk models. The first-passage-time approach extends the original Merton [1974. Journal of Finance 29, 449-470] model by accounting for the fact that the default may occur not only at the debt's maturity, but also prior to this date. Default happens when the firm value process crosses an exhaust barrier. In contrast, this paper defines default as the first time the firm value process crosses a barrier, and the area under the barrier is greater than the exogenous level. This technique is used to price risky debt as an example.

JEL Classification: G12, G13, G33.

Keywords: Credit risk, Structural model, Brownian area.

Published in: Finance Research Letters, Vol. 3, No. 3, (September 2006), pp. 165-172.

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