From actual to risk-neutral default probabilities: Merton and beyond

ABSTRACT Practitioners frequently price credit instruments by using real-world quantities (probability of default, expected loss) and adding a risk premium.We analyze the credit risk premia that are implied by structural models of default.We first analyze a Merton framework and find that credit risk premia constitute a significant part of model-implied spreads and that this part increases with increasing credit quality. Furthermore, credit risk premia are hardly affected by moving to more advanced structural models of default. However, two drivers can be identified: the default timing effect, ie, credit risk premia are lower if the conditional default time is small, and the effect of current asset value uncertainty, ie, credit risk premia are higher as a result of uncertainty about the current asset value.