# Generalizing Merton’s approach of pricing risky debt: some closed form results

## Abstract

In this work, I generalize Merton’s approach of pricing risky debt to the case where the interest rate risk is modeled by the CIR term structure. Closed form result for pricing the debt is given for the case where the firm value has non-zero correlation with the interest rate. This extends previous closed form pricing formular of zero-correlation case to the generic one of non-zero correlation between the firm value and the interest rate.

preprint: TD Bank and UW  

One well known approach of pricing risky debt was pioneered by Merton a long time ago. Within the framework, one assumes a stochastic process for the firm value and treats the risky debt as a option. In Merton’s original work, he assumed that the interest rate is constant and that the default event of the debt can only occur at the time of maturity. Closed form results for pricing the risky debt were given explicitly. As he has pointed out, one can also study the case when stochastic interest rate is taken into account. This can easily be achieved by using Merton’s work that generalized Black-Scholes formular of the option pricing with stochastic interest rate.

However, one has to make the assumption that the bond process of the stochastic interest rate has a non-stochastic volatility which is allowed to be deterministic time-dependent. Therefore, Shimko etc  applied Merton’s results to the case of stochastic interest rate described by the Vasicek model, the bond process of which has a non-stochastic volatility. However, they were unable to handle the case where the interest rate is modeled with the CIR term structure, as the CIR interest rate model will give rise to a bond process having stochastic volatility. It remained open whether one can give a similar closed form results for the risky debt when the interest rate risk is modeled with CIR term structure. In one recent work, I gave the closed form pricing formular for the risky debt in the case where CIR term structure is used for the default-free interest rate. However, using the moment generating functional, one has to assume that the firm value is uncorrelated with the interest rate. In this paper, I extend my closed form results of pricing risky debt to the generic case where the correlation between the firm value and the interest rate is nonzero.

Let us first assume a probability space denoted by $`(\mathrm{\Omega },P,\{F_t\},F)`$, with the filtration $`\{F_t\}`$. Consider the value of the firm that is described by the following process

$$\frac{dV}{V}=\mu dt+\sigma dZ_1,$$
(1)   
where $`Z_1`$ is a Brownian motion in the probability space. The interest rate process is assumed to be the one given by Cox-Ingersoll-Ross:

$$dr=(a\beta r)dt+\eta dZ_2,$$
(2)   
where $`\eta =\sigma _rr^{1/2}`$ with $`\sigma _r`$ as a constant. The co-quadratic variational process is $`[Z_1,Z_2]=\rho t`$. The correlation coefficient $`\rho `$ is a non-zero constant during the following consideration.

The assumptions in Merton’s paper are also made here. The firm value is assumed to be independent of its capital structure by assuming that MM theorem is valid. The firm issues debt and equity. The total value of the firm is the sum of equity and debt. The PDE satisfied by the equity is given by

$$H_\tau =\frac{\sigma ^2}{2}V^2H_{VV}+\rho \eta \sigma VH_{Vr}+\frac{\eta ^2}{2}H_{rr}+rVH_V+(\alpha \beta r)H_rrH$$
(3)   
where $`H=H(V,r,Tt)`$ and $`\tau =Tt`$ is time to the maturity, and $`\alpha `$ is sum of $`a`$ plus the constant representing the market price of the interest rate risk. At $`\tau =0`$, the equity should satisfy the boundary condition that $`H=max(0,V(T)B)`$, where $`B`$ is the face value of the debt issued by the firm maturing at time $`T`$. The risky debt price is therefore given by $`Y=V(t)H(V,r,Tt)`$. For simplicity, it is assumed here, as Merton did, that event of default of the risky debt can only occur at the time of maturity.

Following the standard risk neutral approach, we write the equity price as below:

$$H=E^Q(e^{_t^Tr(s)𝑑s}max(0,V(T)B)|F_t),$$
(4)   
where the expectation $`E^Q`$ means that in the risk-neutral-adjusted world. In this risk-neutral world, the firm value and the interest rate will follow the stochastic differential equations as

$`dlnV=(r{\displaystyle \frac{1}{2}}\sigma ^2)dt+\sigma d\widehat{Z}_1`$ (5)   
$`dr=(\alpha \beta r)dt+\eta d\widehat{Z}_2.`$ (6)   
Here, both $`\widehat{Z}_1`$ and $`\widehat{Z}_2`$ are Wiener processes in the risk-neutral world, and the co-quadratic process is $`[\widehat{Z}_1,\widehat{Z}_2]=\rho t`$. In principle, one can go on with Monte-Carlo simulation based on the above formular Eq.(4) and Eq.(6). However, we are interested in finding closed form result for the equity price here.

In the risk-neutral world, the two Brownian motions $`\widehat{Z}_1`$ and $`\widehat{Z}_2`$ can be represented in the following way. Suppose that $`X`$ and $`Y`$ are two independent Brownian motions in the risk-neutral world. We can find such independent Brownian motions that $`\widehat{Z}_1=\rho X+\sqrt{(1\rho ^2)}Y`$, and $`\widehat{Z}_2=X`$. The stochastic differential equation for the firm value is governed by

$$dlnV=[rdt+\sigma \rho dX\frac{1}{2}\sigma ^2\rho ^2dt]\frac{1}{2}\sigma ^2(1\rho ^2)dt+\sqrt{(1\rho ^2)}\sigma dY,$$
(7)   
where one is working in the risk-neutral world.

Conditional on that the sample path $`\{X\}`$ of the Brownian motion $`X`$ is given for time interval $`[t,T]`$, let us consider the following expectation

$$h=E^Q(e^{_t^Tr(s)𝑑s}max(V(T)B,0)|F_t,\{X\})=e^{_t^Tr(s)𝑑s}E^Q(max(V(T)B,0)|F_t,\{X\})$$
(8)   
This conditional expectation can be computed by standard way as dealing with Black-Scholes case. It is found that

$$h=e^{\sigma \rho _t^T𝑑X}e^{\frac{1}{2}\sigma ^2\rho ^2(Tt)}[V(t)N(d_1)Be^{(_t^Tr(s)𝑑s\frac{1}{2}\sigma ^2\rho ^2(Tt)+\sigma \rho _t^T𝑑X)}N(d_2)],$$
(9)   
where $`N(d)`$ is the standard accumulative function of normal distribution $`N(0,1)`$ and

$$d_{1,2}=\frac{ln(V(t)/B)+[_t^Tr(s)𝑑s\frac{1}{2}\rho ^2\sigma ^2(Tt)+\sigma \rho _t^T𝑑X\pm (1/2)\sigma ^2(1\rho ^2)(Tt)]}{\sigma \sqrt{(1\rho ^2)(Tt)}}.$$
(10)   
Let us denote $`g(m,W)`$ the probability density for $`_t^Tr(s)𝑑s`$ to be in the region $`[m,m+dm]`$, conditional on that $`W=_t^T𝑑X`$ is fixed. In the following we will show that $`g(m,W)`$ is independent of the variable $`W`$. The equity price of the firm can be represented as

$$H=_{\mathrm{}}^+\mathrm{}P(W)𝑑W_0^+\mathrm{}g(m)𝑑m[e^{\sigma \rho W}e^{\frac{1}{2}\sigma ^2\rho ^2(Tt)}V(t)N(d_1)Be^mN(d_2)],$$
(11)   
where $`P(W)`$ is normal distribution density, $`P(W)=exp(0.5W^2/(Tt))/\sqrt{2\pi (Tt)}`$, and

$$d_{1,2}=\frac{ln(V(t)/B)+[m\frac{1}{2}\rho ^2\sigma ^2(Tt)+\sigma \rho W\pm (1/2)\sigma ^2(1\rho ^2)(Tt)]}{\sigma \sqrt{(1\rho ^2)(Tt)}}.$$
(12)   
The distribution function $`g(m)`$ can be found from the moment generating functional. For the Cox-Ingersoll-Ross term structure, the density function $`g(m)`$ can be found easily. Consider the moment generating function

$$I(x)=E^Q(e^{x_t^Tr(s)𝑑s}|F_t)=_0^{\mathrm{}}e^{mx}g(m)𝑑m,$$
(13)   
where $`x`$ is any non-zero numbers. Using the bond price of Cox-Ingersoll-Ross, we find the moment generating function. For CIR term structure, stochastic differential equation governing the short rate is $`dr=(\alpha \beta r)dt+\sigma _r\sqrt{r}d\widehat{Z}_2`$, will remain unchanged under the scaling transformation

$`rxr`$ (14)   
$`\beta \beta `$ (15)   
$`\alpha x\alpha `$ (16)   
$`\sigma _rx^{1/2}\sigma _r,`$ (17)   
where $`x`$ is any positive real number. Denote $`D(r(t);\alpha ,\beta ,\sigma _r,Tt)=E^Q(e^{_t^Tr(s)𝑑s}|F_t)`$ the riskless zero-coupon bond price at time $`t`$ whose payoff at maturity $`T`$ is one. The exact closed form of this zero-coupon bond price was provided explicitly. We obtain

$$I(x)=D(xr(t),x\alpha ,\beta ,x^{1/2}\sigma _r,Tt)=_0^{\mathrm{}}g(m)e^{xm}𝑑m.$$
(18)   
Doing inverse transformation, we will be able to find the density function $`g(m)`$.

In order to see why $`g(m,W)`$ is independent of $`W`$, we first look at the discrete version of $`_t^Tr(s)𝑑s`$. In the discrete version, we see that $`W`$ dependence will only make higher order contribution. Therefore, in the continuous limit, the density distribution of $`_t^Tr(s)𝑑s`$ for given $`W`$ will not have $`W`$ dependence. This is why we can represent the equity price in terms of two double integral as Eq.(11). The price of the risky debt that pays $`B`$ dollars at time of maturity $`T`$ is simple given by $`V(t)H`$.

In summary, we have generalized Merton’s approach of pricing risky debt to the situation where the interest rate risk is modeled with the CIR term structure. Exact closed forms for pricing risky debt are provided explicitly. This goes beyond the situation where the riskless bond process has non-stochastic volatility (such as for Vasicek interest rate model) and the option pricing can be handled by Merton’s generalized Black-Scholes method.

Email address:d6wang@barrow.uwaterloo.ca. I am indebted to Professors P. Boyle and D. McLeish for the finance theories I learned from them. Conversations with Prof. K. S. Tan of UW, Dr. Hou-Ben Huang and Dr. Z. Jiang of TD Securities, Dr. Bart Sisk and Dr. A. Benn of TD Bank, Dr. Daiwai Li and Dr. Craig Liu of Royal Bank, Dr. ChongHui Liu and Dr. J. Faridani of Scotia Bank, are gratefully knowledged. I also wish to thank Dr. Rama Cont for informative communication. The opinions of this article are those of the author’s, and they do not necessarily reflect the institutions the author is affiliated with. Any errors of this article are mine.

After this work was completed, Dr. E. Hofstetter of Imperial College informed me of the most recent work of semi-reduced model approach of pricing default debt. I am grateful for the communication.