Bruche, Max
(2005)
Structural models of corporate bond prices.
PhD thesis, London School of Economics and Political Science.
Abstract
In 1974, Merton wrote a seminal paper that explained how the then recently presented Black-Scholes model could be applied to the pricing of corporate debt. Many extensions of this model followed. The family of models is sometimes referred to as the family of structural models of corporate bond prices. It has found applications in bond pricing and risk management, but appears to have a more mixed empirical record than the so-called reduced-form models (e.g. Duffie and Singleton 1999), and is often considered imprecise. As a consequence, it is often avoided in pricing and hedging applications. This thesis examines three possible avenues for improving the performance of structural models: 1. Strategic interaction between debtors: Possible "Coordination failures" - races to recover value that can dismember firms - are a very important form of strategic interaction between debtors that can have a large influence on the value of debt. 2. The econometrics of structural models: The classic "calibration" methodology widely employed in the literature is an ad-hoc procedure that has severe problems from an econometric perspective. This thesis proposes a filtering-based approach instead that is demonstrably superior. 3. The non-default component of spreads: Corporate bond prices most probably do not only represent credit risk, but also other types of risk (e.g. liquidity risk). This thesis attempts to quantify and assess this non-default component.
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