Pricing credit risk

Merton models

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The measurement of credit risk is one of the most active areas of modern finance. The advent of credit derivatives has heightened the need to capture credit exposures even further. In 1974, the publication of Robert Merton’s academic paper1 introduced a new way of analysing corporate debt by linking it to a company’s market capitalisation, thereby quantitatively measuring credit risk. Effectively, Merton treated equity as a call option on a company’s assets, with the strike at the total liab

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