Can a Normal Firm Value Diffusion Process Improve the Performance of the Structural Approach to Pricing Corporate Liabilities?

Abstract

We derive the pricing formulas for corporate liabilities by integrating their loss functions with firm value distributions from a normal and a lognormal firm value diffusion process (FVDP). By using credit spreads as the input to the pricing formulas, we find that the credit spread-implied asset value volatility from the lognormal FVDP is much higher than the empirically estimated asset value volatility for investment-grade companies, whereas the spread-implied asset volatility from the normal FVDP is almost identical to the estimated asset volatility for companies with different leverage ratios. Consequently, the normal FVDP can explain (i) the observed level of credit spreads when calibrated to historical default-loss experience, and (ii) the expected return on the equity market from traded credit spreads.