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Merton’s model, credit risk and volatility skews - page 12 / 26

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14

John C. Hull, Izzy Nelken and Alan D. White

FIGURE 1 Relationship between CDS spread and implied spread for ImpVol implementation of Merton’s model.

450

400

350

CDS spread

300

250

200

BOW DOW MER

150

100

50

0

0

50

100

150

200

250

Implied spread (ImpVol implementation)

The three companies are Merrill Lynch (MER), Bowater (BOW) and Dow Chemicals (DOW). The ImpVol implementation of Mertons model is the implementation we propose in Equations (8) and (9).

FIGURE 2 Relationship between CDS spread and implied spread for Trad implementation of Mertons model.

450

400

350

CDS spread

300

250

200

BOW DOW MER

150

100

50

0

0

50

100

150

200

250

Implied spread (Trad implementation)

The three firms are Merrill Lynch (MER), Bowater (BOW) and Dow Chemicals (DOW). The Trad implementation is the traditional implementation in Equations (1) and (2).

Journal of Credit Risk

Volume 1/Number 1, Winter 2004/05

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