Abstract
According to a recent study, consideration of a countercyclical default boundary helps explain observed credit spreads. In light of this assertion, the purpose of this paper is to introduce a simple structural model with a countercyclical default boundary based on stock market performance. Through the simple formation of a default boundary, we are able to easily obtain a formula for credit spreads. This paper demonstrates that our simple structural model can generate credit spreads that are closer to observed credit spreads than those generated by the existing structural model. We extend our basic model and show how credit spreads are affected by stochastic interest rates or jumps in both firm value and the default boundary. We also consider an alternative default boundary linked to individual stock price performance.
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