June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 53 of 92 The benefit of this approach is that it is prospective looking, as opposed to historical, and the data needed to execute this method is fairly straight forward to obtain. The following outline some of the weaknesses of this approach • Bond markets may be illiquid, resulting in prices that are not indicative of the risk. • Matching the tenor of the corporate and Treasury bond can be tricky • The zero-coupon spread over Treasuries does not compensate fully for expected losses. Other aspects, such as liquidity, taxes, and regulatory issues, can also account for some portion of the spread over treasuries, thereby distorting the true credit risk component. 5.5. Equity Based Approach The Equity based approach, also known as the Merton Model, can be the most informative of all approaches but it can also be the most complex to implement. The premise of this approach is that the equity of a company is a call option on the assets of that company with a strike equal to the debt.20 The primary benefits of this approach is that the capital structure of the counterparty is taken into consideration and the approach attempts to address why companies default.21 It scrutinizes each individual counterparties’ capital structure instead of lumping companies into credit rating categories. Also, the approach is a prospective, forward looking method that is based on highly liquid instruments that capture all market information concerning a particular counterparty. The basic equation is as follows: ET = max(VT – D, 0) Where ET: Value of company’s equity at time T VT: Value of company’s assets at time T D: Amount of debt interest and principle due at time T Incorporating this concept into Black-Scholes produces the formulas for the value of equity as a call option as Eo = VoN(d1) – De-rTN(d2) (1) Where 20 Options, Futures, and Other Derivatives. 4th Edition. John C. Hull. Prentice Hall Inc. 2000. Pg 630. 21 Energy Modeling. Credit Risk Management for the Energy Industry – Some Perspectives. V. Kaminsky, V. Shanbhogue. Risk Books. 2005. pg. 344. Eo: Current equity value Vo: Current asset value D: Current debt level σV: Volatility of assets σE: Volatility of equity r: Risk free rate