Multivariate Pricing of Capital Structure Derivativeswith Stochastic Smiles and Skews

We develop a convenient structural framework for the joint model-ing of credit spreads, stock prices, stock options and basket creditderivatives, using a multivariate structural ¯rm value model withskewed asset returns. We show that our setting successfully addressesseveral empirical facts, which are not easily accounted for in Merton's(1974) structural model. First, stochastic volatility and left-skewedasset returns increase corporate credit spreads to more realistic lev-els, at short maturities and for low ¯rm leverage. Second, our multi-factor volatility structure is consistent with no-arbitrage violations rel-ative to Merton's model, such as positive comovement between creditspreads and stock returns. Third, our model generates endogenouslya stochastic skewness of stock returns, which is a key feature for ex-plaining the dynamics of individual option smiles.[...]