Mimicking Credit Ratings by a Perpetual-Debt Structural Model

In this paper, we outline the general lines of a structural model that is based on the Leland model (1994), but differs from its assumptions about the tax regime. In the revised model, which we call the Perpetual-Debt Structural Model (PDSM), stocks are equivalent to a portfolio that contains a perpetual American option to default. This paper offers a first empirical test of the model. Essentially, the question is: “Is the PDSM sufficiently flexible to give default probabilities consistent with those historically estimated by Moody’s?”. As we will see, the answer is positive. The paper contains a simple firm-level application. The PDSM risk indicators have been used to define the “market rating” of Deutsche Bank.