Kay Giesecke

Structural default models, starting with Merton, 1974, specify that default occurs when the value of the firm falls and hits a boundary that is a function of the firm's debt liabilities. This means that default probability, and therefore the credit spread on the firm's short-term debt, will be very close to zero when firm value is well above the barrier. But short-term spreads in the real world are not zero. In reduced-form models, default follows a random process that may hit at any time. This allows positive short-term spreads, but the cause of default is no longer modeled. In this article, Giesecke and Goldberg offer a hybrid approach, in which default occurs when firm value hits a barrier, but investors are uncertain about exactly where the barrier is. This is a very plausible assumption for real-world debt markets and it leads to a model with very plausible properties, including a connection between the value of the firm's assets relative to its debt obligations, and positive credit spreads even at t...