Extending the Merton model with applications to credit value adjustment

Following the global financial crisis, the measurement of counterparty credit risk has become an essential part of the Basel III accord with credit value adjustment being one of the most prominent components of this concept. In this study, we extend the Merton structural credit risk model for counterparty credit risk calculation in the context of calculating the credit value adjustment mainly by estimating the probability of default. We improve the Merton model in a variance-convoluted-gamma environment to include default dependence between counterparties through a linear factor decomposition framework. This allows one to tackle dependence through a systematic common component. Our set-up allows for easier, faster and more accurate fitting for the credit spread. Results confirm that use of the variance-gamma-convolution clearly solves the vanishing credit spread problem for short time-to-maturity or low leverage cases compared to a Brownian motion environment and its modifications.