The Fractional Merton Model: A New Approach To Credit Risk Pricing
Source: City University of London (Cass)
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. They also compute 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 higher than the spreads predicted by the Merton model. This favours the conclusion that fractional Merton model can explain market spreads better than the Merton model.