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Explaining credit ratings through a perpetual-debt structural model

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  • Gaia Barone

Abstract

In this paper, we calibrate a perpetual-debt structural model (PDSM) by using Moody’s historical credit ratings. In the PDSM, stocks are equivalent to a portfolio that contains a perpetual American option to default, and bonds are perpetual securities whose face value plays the role of a “notional†capital used to calculate the amount of interest due in the given unit of time. The key question is whether the PDSM can generate (real-world) default probabilities consistent with those historically estimated by Moody’s, under empirically reasonable parameter choices. The answer is yes. The paper also contains an application at the level of a single listed firm: Deutsche Bank. The PDSM risk indicators are used to assign a credit rating to the firm that is consistent with Moody’s scale.

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Handle: RePEc:rsk:journ1:7857131
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File URL: https://www.risk.net/system/files/digital_asset/2021-10/Explaining_credit_ratings_through_a_perpetual-debt_structural_model_final.pdf
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