Explaining CDS prices with Merton’s model before and after the Lehman default

Abstract

We examine whether CDS prices around the Credit Crisis can be explained with Merton's model. First we invert the model with market prices to reveal skewed volatility smiles over the whole 2005-2012 period. Then we calibrate the model to pre-Crisis data in two novel ways that allow for skewness, one based on equity-index options (MEIV) and the other on the sensitivity of CDS prices to equity volatility (MSKEW). In out-of-sample forecasts both calibrations match the in-Crisis peak of prices, but the second is better at capturing the systematic component of prices thereafter. Average CDS prices remain at twice their pre-Crisis level long after that event; the MSKEW calibration demonstrates that this is due to extra idiosyncratic risks, which are important for some firms but have negligible impact on others.