| This study focused on credit risk modeling, and attempted to examine the relationship between credit spreads and the measurement of distant-to-default. In the first part we developed a contingent-claims valuation model on a credit risky bond to compare three alternative default trigger conditions, i.e., the positive net wealth requirement, the cash-flow-triggered default, and the endogenously default trigger conditions. In the second part, we obtained some analytical results on the relationship between credit spreads and debt ratio, and distant-to-default. In particular, we derived analytical formulas showing that credit spreads on a risky bond can be expressed as a function of distant-to-default of the issuing firm.;Numerical implementation showed that the endogenous default triggering value is not always higher than other two exogenous default trigger conditions; the same uncertainty is also true for the bond price and thus credit spreads. However, without protective covenants, a bond is more likely to default when interest rate level actually decreases due to the deterioration of the general economy condition. The lower interest rate raises endogenous default triggering value.;As to the distant-to-default and credit spreads, we found that credit spread moves downward when the risk-free rate increases. Meanwhile, the lower value of credit spread corresponds to the higher value of distant-to-default. In addition, this study found no matter what default trigger condition is applied, credit risk models based on single bond, tend to underestimate a firm's debt ratio and thus credit spreads. |
