Title: Post global financial crisis modelling: credit risk for firms that are too big to fail

Authors: Ephraim Clark; Sovan Mitra; Octave Jokung

Addresses: Middlesex University, London, UK ' University of Liverpool, Liverpool, UK ' Université de Valenciennes, Valenciennes, France

Abstract: The global financial crisis has brought in question the validity of credit risk models. The firms that are 'too big to fail' are frequently discussed in the media, and continue to borrow rather than defaulting. In this paper we propose a new credit risk model for firms that are too big to fail. We propose a structural model of credit risk but model credit risk as a real option. We derive a closed form solution for the option to default and take into account the borrowing practices of systemically important firms. We develop our model to take into account economic factors using regime switching, and derive an option pricing solution under such a process. Finally, we obtain solutions for hedging the option to default, for markets where incompleteness exists for such options. We conduct numerical experiments to calculate the option to default at different debt values and volatility.

Keywords: credit risk; real options; too big to fail; financial crisis; hedging.

DOI: 10.1504/IJFMD.2019.101235

International Journal of Financial Markets and Derivatives, 2019 Vol.7 No.1, pp.15 - 39

Received: 18 Sep 2018
Accepted: 28 Oct 2018
Published online: 29 Jul 2019 *

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