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IAI Actuarial Core Principles · Economic Modelling · Simple models for credit risk

Holding other Merton model inputs constant, which change would increase the credit spread on the firm's zero-coupon debt?

An increase in asset volatility raises the credit spread. Debt is a risk-free bond less a put on the firm's assets, and higher volatility makes the put more valuable, lowering the debt's value and widening the spread, while higher assets or lower debt reduce it.

  1. AA rise in the firm's asset value
  2. BA reduction in the volatility of the firm's assets
  3. CA shortening of the debt's time to maturity for a firm currently solvent in the model, with a very high asset value
  4. DAn increase in the volatility of the firm's assetsCorrect
  5. A reduction in the face value of the debt

Explanation

Debt equals a risk-free bond minus a put on assets. Higher asset volatility raises the put's value, so debt value falls and the spread widens. Higher assets or lower face value reduce default probability and spread. Lower volatility reduces the put value.

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