PROFESSOR: A more physical sense of what's

going on in the Merton model is obtained

by considering what happens along a single sample
path for asset value over time.
In this example here, the face value of debt
is the solid red line, and the asset value
winds up below that value at the debt maturity date.
The loss given default on that path
is just the difference between the face value
and the asset value on that maturity date.
You can think of the model is equivalent to running many risk
neutral Monte Carlo paths of lognormal model for asset
prices and calculating the present value of the expected
loss given default by averaging across those many paths.
With the predicted bond price from the Merton model,
it's straightforward to derive the corresponding credit
spread.
We start with the bond price D0 and find the yield
to maturity on the bond on a continuous basis
from this formula here.
Substituting in the expression for D0
that's based on the price of a risk free bond minus the price
of a put option, we can rearrange
and solve for the credit spread, which is given here.
As you'd expect, the spread gets wider the more valuable
the put option, which of course equals the value
of the expected losses.

How the credits spread moves over time

depends on the model parameters, and it's
especially sensitive to asset volatility and the leverage
ratio, D divided by A.
These graphs show the relationship
for two different levels of assumed asset volatility
and for a range of leverage ratios.
The graphs reveal some counterfactual predictions
of the model.
One is that the credit spread is close to 0
when the bond is nearing maturity.
The technical reason for that is because the price of the asset
is assumed to follow a continuous path,
and there's essentially no chance
over a short horizon of a price move
that is adverse enough for the possibility of loss to become
significant.
A second problem is that the predicted magnitudes
of the credit spreads are far lower than those
observed in the data.
As I mentioned earlier, one reason for that
is that the empirical credit spread
reflects more than just the direct cost of default losses.
Finally, the pattern of sharply declining credit spreads
over time for some parameterizations
is also contrary to what is observed in the market.
The reason in the model for the declining spreads
is that assets on average grow and the face value of the debt
is fixed, which has the effect of reducing
the likelihood of default over time as the leverage
ratio tends to shrink.
Despite these shortcomings, it's convenient to use this model
to develop an understanding of the relative pricing
of some more complicated debt structures,
and we'll turn to that next.
We'll also discuss some modifications
to the basic model that address some of these shortcomings
and that produce more reliable price estimates.
Corporations often issue a combination
of senior and junior debt.
Doing that may lower the total cost of debt financing
by creating securities that appeal
to clienteles with different tolerances for risk and return.
In the event of default, the senior debt
is fully repaid before the junior debt
holders receive any payments.
Both groups of debt holders must be
repaid before any value goes to the equity holders.
To take a simple example, imagine
that a firm has two issues of zero-coupon bonds
outstanding, both maturing at the same time Cap(t).
Fs is the face value of the senior debt,
and Fj is the face value of the junior debt.
This table describes the payoffs to the different claimants
as a function of the asset value at maturity, V sub t.
If the asset value is less than the face
value of the senior debt, the entire value
goes to pay the senior debt holders.
If the asset value is enough to pay
the senior debt holders but less than the sum of the face
value of the junior and the senior debt,
then the junior debt holders get the remaining value
after the senior debt holders are paid in full.
Finally, if the asset value is greater
than the sum of the face value of the junior and senior debt,
there isn't a default. The bondholders are paid in full,
and any residual asset value goes to the equity holders.
That description of the payoffs can
be translated into expressions that
are in terms of the value of call options
on the underlying assets of the firm.
The senior debt holders have a position
that's equivalent to owning the assets of the firm
and writing a call option.

That call option has a strike price

equal to the face value of their debt.
Then the junior debt holders are long that same call option,
and they're short another call option with the strike price
equal to the sum of the face value of the senior
and the junior debt.
Finally, as we know, the equity holders
are long the call option written by the junior debt
holders, which has a strike price of the sum of the face
values of the debt.
For pricing more complicated structured claims,
the stochastic model for asset prices
can be implemented on a risk neutral binomial tree
or with Monte Carlo that can then
be used for finding and pricing the payoffs
to different claimants.