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Credit Risk [26]

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Bullet points include: Basic intuition: equity is a call option written on the firm’s underlying assets, with the strike price being its liabilities. Firm with assets V at future time T and due to repay D in pure discount debt at time T. Payoff to equity: max(V – D , 0), i.e. payoff on call with strike D. Payoff to debt: min(D , V) = D + min(0 , V – D) = D – max(D – V , 0) (If V >= 0 !), i.e. payoff on safe claim of D minus payoff on a put with strike D. So, use equity and liability data to infer level and volatility of a firm’s underlying asset value (here V) perhaps repeating for multiple firms to estimate correlations of inferred asset values. Liability data here refers to accounting data etc. quantifying firm’s liabilities

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