The Fractional Merton Model: A New Approach To Credit Risk Pricing (Revised)
Source: City University of London (Cass)
Merton model is known to underestimate credit spreads. In this paper the authors develop the theoretical framework of the fractional Merton model, which allows to embed long memory properties of spreads in a straightforward manner in a credit risk pricing model. The authors carry out an extensive sensitivity analysis exercise and compute the spread sensitivities to the long memory parameter, firm leverage, firm volatility and variance, and risky debt time to maturity. This paper also computes sensitivities of the equity, risky debt, risk-neutral default probability and option to default to long memory. This paper shows that theoretical spreads of the fractional Merton model are larger than the spreads predicted by the Merton model and hence closer to market spreads.