Term Default, Balloon Risk, and Credit Risk in Commercial Mortgages

The contingent claims model has been used to value a variety of risky debt securities since the seminal work of Black and Scholes [1973]. The model is also called the option-theoretic model or the structural model. It treats a debt security as a contingent claim against the value of an underlying asset. In 1974, Merton first applied this methodology to estimate the value of a defaultable zero-coupon bond; since then, many authors have applied it to value corporate debt. Extensions of Merton [1974] include Black and Cox [1976], who incorporate classes of senior and junior debt; Geske [1977], who considers bonds that make coupon payments; and Ho and Singer [1984], who value bonds with sinking fund provisions. Other authors modify Merton's assumption of a flat term structure.1 Despite the substantial literature, the research has been of limited empirical success in explaining the price behavior of corporat