11-1 Option Models: Chapter 11 Part F Employ option pricing methods to evaluate the option to default. Used by many of the largest banks to monitor credit.

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Presentation transcript:

11-1 Option Models: Chapter 11 Part F Employ option pricing methods to evaluate the option to default. Used by many of the largest banks to monitor credit risk. Theory developed by Bob Merton in 1974 Only implemented recently KMV Corporation markets this model quite widely.

11-2 Key Factors  Capital Structure How much equity “cushion” ? Equity at market value  Incorporates the market’s evaluation of many factors  Volatility of the business (Assets) High volatility increases chances that the equity cushion will be violated

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11-6 Xerox Corporation Historical Credit Risk Adjusted Spread to Agencies December 1997 – June 2000 Spread source: Goldman, Sachs & Co. Spread (Basis Points)

11-7 Xerox Corporation Historical Credit Risk Adjusted Spread to Agencies and Credit Rating December 1997 – October 2000 Spread source: Goldman, Sachs & Co. Spread (Basis Points)Credit Rating BBB- BBB A