The Down-and-Out-Call Option Model of Default Risk: An Application of Genetic Algorithms

Abstract

Abstract This paper compares results obtained from two different structural option based models of credit risk derived from Merton (1974). The traditional Merton model is computed using calculus based algorithms and used as a benchmark. The Down-and-Out Call Equity (DOC) option model is solved using genetic algorithms (GA). Results for the DOC option model using GA are compared to a previous study which utilized a hybrid of branch-and-bound algorithm and bisection search method to solve the DOC option model. The paper finds GA yields better precision and convergence rates than the combinatorial methods based algorithm.