The use of compound options for credit risk modelling

When a company experiences credit-rating downgrades, its equity inevitably drops by a sizable amount as well as the prices of the derivative contracts written on the company’s equity and debt react accordingly. Stemming from the works of Merton (1974), Geske (1977) and Geske (1979), a new structural model of default is introduced. As the reference firm is assumed to have issued n bonds maturating at different future dates, the firm’s equity is modelled as an n-fold compound option written on the firm’s assets and struck at the face values of the bonds outstanding. This framework is used across the chapters of the thesis, each constituting a different and original piece of research.