City Research Online

Abstract

Borrowing from the principle of refraction in optics, we develop an option pricing model that allows the process of the underlying asset to change upon touching a barrier, while also developing a structural credit risk model. To do so, we extend the Black-and-Scholes model and then the Merton model to allow regime-shifts when a barrier is crossed. Our credit model documents that the possibility of the firm value reaching a certain level below the initial firm value, which triggers a change in the firm’s policy, has an impact in the loan value. As the policy change is reflected in the underlying asset process, the value of the loan decreases and the credit spreads increase. Our work highlights the importance of accounting for regime-shifts and their effects on loan pricing in dynamic market conditions.

Publication Type:	Article
Additional Information:	© 2025. This manuscript version is made available under the CC-BY-NC-ND 4.0 license https://creativecommons.org/licenses/by-nc-nd/4.0/
Publisher Keywords:	Options, Regime-Shift, Loans, Bonds
Subjects:	H Social Sciences > HG Finance
Departments:	Bayes Business School Bayes Business School > Finance
SWORD Depositor:	Symplectic Administrator

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