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Idiosyncratic Risk, Systematic Risk and Stochastic Volatility: An Implementation of Merton's Credit Risk Valuation

by Hayette Gatfaoui of Groupe ESC Rouen & the University of Technology, Sydney

February 2007

Abstract: We extend the credit risk valuation framework introduced by Gatfaoui (2003) to stochastic volatility models. We state a general setting for valuing risky debt in the light of systematic risk and idiosyncratic risk, which are known to affect each risky asset in the financial market. The option nature of corporate debt allows then to account for the well-known volatility smile along with two documented determinants, namely stochastic volatility and market risk. Under some regularity conditions, we specify diffusion functionals leading to an asymptotically (relative to time) mean reverting volatility process. The behavior of such a specification is studied along with simulation techniques since debt is valued via a call on the firm assets value. Specifically, our examination resorts to Monte Carlo accelerators to realize related simulations. First, we consider the evolution of stochastic volatility for given parameter values. Then, we assess its impact on both risky debt and the related credit spread.

JEL Classification: G13, G33.

Keywords: Credit risk, credit spread, idiosyncratic risk, stochastic volatility, systematic risk.

Gatfaoui H., 2003, Risk Disaggregation and credit Valuation in a Merton Framework, Journal of Risk Finance, Vol. 4, No. 3, pp. 27-42.

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