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- Title
Structural Default Modeling: A Lattice-Based Approach.
- Authors
Jabbour, George M.; Kramin, Marat V.; Young, Stephen D.
- Abstract
It is well known that corporate capital structures may be modeled via an option theoretic approach where equity holders are long a call option with the strike price equal to the level of firm debt. In the case of two tranches of debt this modeling can easily be done using compound option formulae. The typical corporate capital structure includes multiple tranches of debt. This article presents a lattice-based approach to structural default modeling for firms with multiple tranches of debt. The lattice described herein uses a combination of backward recursion and forward induction to calculate firm values and a term structure of unconditional and conditional risk-neutral survival and default probability measures in a computationally efficient manner. Further, the lattice construction allows for a merging of the firm-value and first-passage approaches to form a hybrid model. The lattice is not limited to simple lognormal dynamics and the structure can be extended to multiple factors. In contrast to reduced-form models, which are used widely for valuation, structural default models have proven to be useful for monitoring credit quality and is the motivation for the model presented herein.
- Subjects
LATTICE theory; DISTRIBUTIVE lattices; MICROECONOMICS; PROBABILITY theory; RECURSION theory; MATHEMATICAL formulas; COMPUTATIONAL complexity
- Publication
Journal of Derivatives, 2010, Vol 17, Issue 4, p44
- ISSN
1074-1240
- Publication type
Article
- DOI
10.3905/jod.2010.17.4.044