Incorporating Equity Derivatives into the CreditGrades Model

Jun 1, 2005

In this paper, we extend the CreditGrades model by using implied volatilities as an alternative to the standard model by way of two approaches. The first approach is to estimate asset volatility by replacing equity volatility with implied volatility, while keeping the same leverage estimate from the standard approach. The second extends the first by not only estimating asset volatility from options data, but also implying leverage from market data (see Hull, Nelken, and White (2005) for a treatment of Merton’s model). The market-based approach will provide a useful complement to the standard model since it will provide better pricing of credit (especially when a firm’s leverage is difficult to estimate) and a more timely credit signal during a crisis.