Incorporating equity derivatives into the CreditGrades model

Robert Stamicar*, Christopher C. Finger*

Abstract

ABSTRACT

In this paper we extend the CreditGrades structural model to include implied volatilities. Analytical formulas that include both asset volatility and leverage are derived for European puts and calls. Incorporating implied volatilities provides an alternative to standard implementations of structural models where asset volatilities are obtained from historical equity volatilities. This is particularly useful as a credit warning signal since we expect implied volatilities to spike during a credit crisis. In addition, implied volatilities can be used to infer not only asset volatility but also leverage. This is helpful when financial data do not accurately reflect the firm’s true leverage levels (such as companies with a large percentage of secured debt) or for firms whose leverages are difficult to estimate.