Berkeley professor to present research on predicting company defaults and how corporate debt should be valued
By: Lauren Otis
Back in 1973 a groundbreaking model was developed by economists Fisher Black and Myron Scholes for the pricing of options. Incorporating work by a third economist, Robert Merton, the Black-Scholes Model is still the basis for the complicated calculations financial analysts use to measure the value of stock options.
In 1997, their work in determining the value of derivatives earned Mr. Scholes and Mr. Merton the Nobel Prize for economics. Mr. Black died in 1995.
Hayne Leland, Arno Rayner Professor of Finance and Management at the Haas School of Business at the University of California at Berkeley, has been advancing the work Mr. Black, Mr. Scholes and Mr. Merton began, and later this month those in the Princeton-area financial community will have a unique opportunity to hear Mr. Leland present his research work when he delivers the 2006 Princeton Lectures in Finance on Sept. 20 to 22 at Princeton University’s Bendheim Center for Finance.
In three lectures on three consecutive days, Mr. Leland will outline his work developing a model for the prediction of the likelihood of a company defaulting on its corporate debt, as well as the closely related question of how that corporate debt should be valued.
"Going back to 1994, it has been an ongoing topic that has been of interest to me," said Mr. Leland in a recent interview as he was preparing for the lectures. Several years ago, when he was invited to deliver the Princeton Lectures in Finance he leapt at the opportunity, Mr. Leland said, because "it was a very prestigious series."
Although he has other research interests, Mr. Leland said he chose to deliver the lectures on his work pricing corporate debt. In their work, Mr. Black, Mr. Scholes and Mr. Merton did allow for the fact that corporate equity and debt could be priced by an option-like methodology, Mr. Leland said, with Mr. Merton being the person who looked most closely at corporate debt. But their models contained flaws, which Mr. Leland said he has spent the past 12 years ironing out.
"For years the question of predicting the likelihood of default risk and pricing has really fallen to the rating agencies," who base their predictions on a rating of default likelihood, with less emphasis on pricing spreads, Mr. Leland said. "For years the Holy Grail has been, can we develop a model to predict those things," he added.
Developing an accurate model for pricing corporate default risk and credit spreads, would be extremely important for investors, in being able to accurately know what to charge for taking the risk of purchasing a company’s debt, as well as for debt issuers, who could accurately predict how much they would have to pay and how much debt they could issue as a result, Mr. Leland said.
Mr. Leland said his work acknowledges that companies don’t necessarily slide gradually into bankruptcy, but can "jump" to insolvency, and recognizes that debt may not be a liquid financial instrument, and may need to be priced with a liquidity premium.
On the first day of his lectures, Mr. Leland said he will survey the work that has been done in the field to date. On the second day, he will present his new model, showing how it does a good job of pricing credit spreads and default ratings. On the final day, he will show that "we can use these models to then ask how much debt should a firm issue how you can use these models to optimize a firm’s financial decisions," Mr. Leland said.
More information on Hayne Leland’s 2006 Princeton Lectures in Finance, on Sept. 20-22, can be found at the Bendheim Center Web site www.princeton.edu/âbcf/ or by calling (609) 258-0770.