While using Merton (or any other) model, is the model-implied yield spread on bonds greater than actual yield spread? And is it possible to estimate actual probablities of default?
1 Answer
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First some remarks in a model agnostic sense. Credit spread is actually thought to be significantly smaller than the actual one (some even say about 1/3 only, for corporates Longstaff 2005 reports the range 5%-25% for the default component), as there are many other factors such as liquidity. For PDs it might be slightly better to use CDS spreads. In any case what you'll get are risk neutral implied PDs, not objective ones; disentangling the "actuarial" credit spread from the proper credit premium is not easy (and beware that many improperly call "premium" the full risk neutral credit spread).
If a model returns a higher spread than the actual one, something has probably gone wrong. What are you calibrating to?
