Modeling Bond Spreads and Credit Default Risk in the Norwegian Financial Market Using Structural Credit Default Models

Abstract

In this study, we examine the credit risk of banking bonds. We apply two option-based credit default models originally derived by Merton and Black and Cox, with the aim of producing objective credit ratings and credit spreads. A credit rating process can never be purely objective and typically credit rating assessments are highly dependent on subjective judgment on the part of credit analysts. We do believe, however, that the credit rating industry might benefit from employing objective methods to help foster consistency in the rating processes (which some CRAs already do, e.g., Moody’s). Employing data from two Norwegian banks, our analysis is designed to capture the characteristics of the Nordic financial bond market. The results indicate that structural models are well suited to computing plausible credit default probabilities, as well as credit spreads and to performing credible credit ratings of Nordic banks, given that the input parameters are properly estimated.