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11-1
Option Models: Chapter 11 Part F
Employ option pricing methods to evaluate the option to default.
Used by many of the largest banks to monitor credit risk.
Theory developed by Bob Merton in 1974 Only implemented recently KMV Corporation markets this model quite
widely.
11-2
Key Factors
Capital Structure How much equity “cushion” ? Equity at market value
Incorporates the market’s evaluation of many factors
Volatility of the business (Assets) High volatility increases chances that the equity
cushion will be violated
11-6
-100
-75
-50
-25
0
25
50
75
100
Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00
Credit Risk Adjusted Spread
Xerox CorporationHistorical Credit Risk Adjusted Spread to Agencies
December 1997 – June 2000
Spread source: Goldman, Sachs & Co.
Spread (Basis Points)
11-7
-100
0
100
200
300
400
500
600
700
800
900
Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00
Credit Risk Adjusted Spread Credit Rating Line 6 Line 7
Xerox CorporationHistorical Credit Risk Adjusted Spread to Agencies and Credit Rating
December 1997 – October 2000
Spread source: Goldman, Sachs & Co.
Spread (Basis Points) Credit Rating
BBB-
BBB
A