Pricing credit risk

The growth of the credit derivatives market has meant that Merton models are increasingly being used as a means of pricing both bonds and credit default swaps. Kate Birchall and Peter Zeitsch of ANZ Investment Bank analyse the evolution of these models

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