Default Risk Modeling Beyond the First-Passage Approximation: Extended Black-Cox Model

TL;DR

This paper extends the Black-Cox model of default risk by incorporating uncertainty and finite default rates, providing analytical formulas that better fit historical default data and improve short-term credit risk valuation.

Contribution

The paper introduces a generalized default risk model with an exact solution, capturing default uncertainty and finite boundary default rates, enhancing accuracy over traditional models.

Findings

Analytical expressions fit historical default data well.

Model captures split credit spread behavior across ratings.

Finite default rate improves short-term credit risk valuation.

Abstract

We develop a generalization of the Black-Cox structural model of default risk. The extended model captures uncertainty related to firm's ability to avoid default even if company's liabilities momentarily exceeding its assets. Diffusion in a linear potential with the radiation boundary condition is used to mimic a company's default process. The exact solution of the corresponding Fokker-Planck equation allows for derivation of analytical expressions for the cumulative probability of default and the relevant hazard rate. Obtained closed formulas fit well the historical data on global corporate defaults and demonstrate the split behavior of credit spreads for bonds of companies in different categories of speculative-grade ratings with varying time to maturity. Introduction of the finite rate of default at the boundary improves valuation of credit risk for short time horizons, which is the key advantage of the proposed model. We also consider the influence of uncertainty in the initial distance to the default barrier on the outcome of the model and demonstrate that this additional source of incomplete information may be responsible for non-zero credit spreads for bonds with very short time to maturity.