Default risk in stochastic volatility models

We consider a stochastic volatility model of the mean-reverting type to describe theevolution of a firm’s values instead of the classical approach by Merton with geometricBrownian motions. We develop an analytical expression for the default probability. Oursimulation results indicate that the stochastic volatility model tends to predict higherdefault probabilities than the corresponding Merton model if a firm’s credit quality isnot too low. Otherwise the stochastic volatility model predicts lower probabilities ofdefault. The results may have implications for various financial applications