Nobel laureate Robert C. Merton challenged traditional models used by investors to measure sovereign and financial system credit risk and proposed an alternative framework during a keynote session at the CFA Institute European Investment Conference.
Merton began by arguing that any definition of sovereign debt should take into account another class of liabilities, top-up guarantees, which aren’t on the balance sheet but are just as real as those that are. For the United States, these guarantees amounted to an astonishing $17 trillion in 2010. “The values of these guarantees are enormous, particularly in times of stress,” Merton said. According to Merton, these explicit and implicit guarantees cause risk to propagate in substantial ways across the various sectors of the economy — household, corporate, financial, banking, and government sectors — as well as across borders. Merton is interested both in understanding what is going on with these guarantees and in measuring and monitoring risks.
Merton’s approach is based on contingent claims analysis (CCA), which models an issuer’s debt as a combination of risk-free debt and a short put option on the issuer’s assets. If the issuer defaults, the issuer has to give up the remaining value of the firm’s assets to the bondholder. The holder of the guarantee receives the promised value of the debt minus the value of assets recovered from the defaulting entity. So, the value of the guarantee, such as a credit default swap (CDS), is analogous to a put option on the assets of a borrower.