Estimating Structural Models of Corporate Bond Prices
by Max Bruche of Centro de Estudios Monetarios y Financieros (CEMFI)
July 30, 2007
Abstract: One of the strengths of structural models (or firm-value based models) of credit (e.g. Merton, 1974) as opposed to reduced-form models (e.g. Jarrow and Turnbull, 1995) is that they directly link the price of equity to default probabilities, and hence to the price of corporate bonds (and credit derivatives). Yet when these models are estimated, the existence of data other than equity prices is typically ignored. This paper describes how all available price data (equity prices, bond prices, possibly credit derivative prices) can be used in estimation, and illustrates that using bond price data in addition to equity price data changes estimates significantly. In this context, the issue of possibly noisy data and/or model error is also discussed.
Previously titled: Estimating Structural Bond Pricing Models via Simulated Maximum Likelihood