H.Y. Wong and K.L. Li (PRC)
Corporate Bond Pricing, Credit Risk, Merton's Model, MLE
In the credit risk modeling literature, there are two dif ferent viewpoints towards the structural model of Merton. Many empirical tests show that the Merton model overesti mates corporate bond prices substantially. However, there are other empirical works defensing that the Merton model is useful in predicting default and performs well in estimat ing deposit insurance fund. In this paper, we argue that the poor performance of the Merton model may be the conse quence of using proxies in empirical studies. Specifically, we show theoretically that using sum of market value of equity and book value of corporate liabilities as a proxy for the market value of corporate assets generates significant bias of overestimating the asset values. It follows that the market value of corporate bond, as a risk-free bond less a put option on corporate asset, would be overestimated un der the Merton approach. We propose that the asset values and volatilities are better estimated with maximum likli hood estimation (MLE). To support this claim, we conduct a simulation and an empirical study. Our empirical results document that, if MLE is adopted, the Merton model can overestimate or underestimate the bond prices with the av erage percentage error of 0.16%.
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