Location of Repository

Testing Merton's model for credit spreads on zero-coupon bonds

By Gordon Gemmill


Structural models for valuing corporate bonds (beginning with Merton (1974)) have been criticised for giving spreads which are (a) too small and (b) have a term structure in which spreads diminish with extra time to maturity. Empirical tests of models are hampered by the complexity of real-world bonds, which have coupons, calls and sinking funds, and also by the complicated and changing capital structures adopted by companies. This paper exploits a new database of zero-coupon bonds issued by closed-end funds in the UK. These companies have very simple capital structures and transparent values for both assets and liabilities. Between 20 and 78 bonds are observable monthly over the period February 1992 to April 2001. Counter to previous research, we find that model and market spreads are on average of similar magnitude. Similar to previous research, market spreads are high (relative to model spreads) for bonds which have low risk and for bonds which are near to maturity. While the observed term-structure of credit spreads is upward-sloping, this may be explained by a predictable drift in leverage over time. On the whole, the results are surprisingly supportive of Merton’s model and suggest that it is important to allow for expected changes in leverage when computing credit spreads

Topics: HG
Publisher: Warwick Business School, Financial Econometrics Research Centre
Year: 2002
OAI identifier: oai:wrap.warwick.ac.uk:1805

Suggested articles



  1. (1997). A Markov Model For The Term Structure Of Credit Risk Spreads," Review of Financial Studies, doi
  2. (2001). A Note of hte Valuation of Risky Corporate Bonds," OR Spektrum, 1999, v21 (1-2), Wang, Mark and Stewart Hodges. "A Reduced-Form Model Incorporating Fundamental Variables," working paper,
  3. (1995). A Simple Approach To Valuing Risky Fixed And Floating Rate Debt," doi
  4. (1984). Contingent Claims Analysis Of Corporate Capital Structures: An Empirical Investigation," doi
  5. (1987). Determinants Of The Ratings And Yields On Corporate Bonds: Tests Of The Contingent Claims Model," doi
  6. (2001). Do Credit Spreads Reflect Stationary Leverage Ratios?," doi
  7. (1993). Does Default Risk In Coupons Affect The Valuation Of Corporate Bonds? A Contingent Claims Model," Financial Management, doi
  8. (2000). Explaining the Rate Spread on Corporate Bonds," doi
  9. (2001). Financial Engineering and Firm Value: A Study of Split-Capital Closed-End Funds," working paper, doi
  10. (2001). Liquidity and Credit Risk,” working paper, doi
  11. (2001). Liquidity and Credit Risk," working paper, London School of Economics, doi
  12. (1999). Modeling Term Structures Of Defaultable Bonds," Review of Financial Studies, doi
  13. (2002). Noise Trading, Costly Arbitrage and Asset Prices: Evidence from Closed-End Funds”, forthcoming, doi
  14. (1974). On The Pricing Of Corporate Debt: The Risk Structure Of Interest Rates," doi
  15. (1996). Optimal Capital Structure, Endogenous Bankruptcy, And The Term Structure Of Credit Spreads," doi
  16. (1999). Pricing Defaultable Bonds: A Middle-Way Approach Between Structural and Reduced-Form Models," working paper, Management School, doi
  17. (1995). Pricing Derivatives On Financial Securities Subject To Credit Risk," doi
  18. (2001). Risk and Valuation of CDOs," doi
  19. (1989). Some Empirical Estimates Of The Risk Structure Of Interest Rates," doi
  20. (1987). The Default Premium And Corporate Bond Experience," doi
  21. (1973). The Pricing Of Options And Corporate Liabilities," doi
  22. (1999). The Slope of the Credit Yield Curve for Speculative-Grade Issuers,” doi
  23. (2000). The Valuation Of Compound Options," doi
  24. (1976). Valuing Corporate Securities: Some Effects Of Bond Indenture Provisions," doi
  25. (1997). Valuing Risky Fixed Rate Debt: An Extension," doi

To submit an update or takedown request for this paper, please submit an Update/Correction/Removal Request.