2025/06/15 by Jagdish Gnawali, Abootaleb Shirvani, Gnawali, Jagdish +3
Economics, Econometrics and Finance · #Computational Finance (q-fin.CP) #Credit Risk and Financial Regulations #FOS: Economics and business #Risk Management (q-fin.RM)
paper · pdf · doi:10.48550/arxiv.2506.12694
openalex publication_date 2025/06/15 · openalex created_date 2025/10/13 · openalex updated_date 2026/07/28
We explore credit risk pricing by modeling equity as a call option and debt as the difference between the firm's asset value and a put option, following the structural framework of the Merton model. Our approach proceeds in two stages: first, we calibrate the asset volatility using the Black-Scholes-Merton (BSM) formula; second, we recover implied mean return and probability surfaces under the physical measure. To achieve this, we construct a recombining binomial tree under the real-world (natural) measure, assuming a fixed initial asset value. The volatility input is taken from a specific region of the implied volatility surface - based on moneyness and maturity - which then informs the calibration of drift and probability. A novel mapping is established between risk-neutral and physical parameters, enabling construction of implied surfaces that reflect the market's credit expectations and offer practical tools for stress testing and credit risk analysis.