A simple continuous measure of credit risk

Abstract

This paper introduces a simple parameterization for the risk-neutral default probability distributions for risky firms that are easily computed from quoted bond prices. The corresponding expected times to default have a particularly simple form and are proposed as a measure for credit risk. Being continuous in nature, times to default provide a much finer measure of risk than those provided by ratings agencies. Comparison with the ratings provided by Moody's and the distance to default measures calculated using the Merton [Merton, R. (1974). On the pricing of corporate debt: the risk structure of interest rates. Journal of Finance, 2(2), 449–470] model shows that the highest rank correlation is found between the proposed time to default measure and Moody's ratings.