A Finance 4335 student emailed me today asking for further details concerning how to calculate “fair” premiums for insurance against the risk of default on debt issued by a limited liability firm. Essentially, “fair” premiums for credit enhancement schemes as described in Problem Set 10 correspond to the values of the (put) options to default reflected in risky corporate debt prices.
For further details, review my Credit Risk lecture note, and also watch my recorded lecture on Credit Risk. Starting at 40:29 in that video, I work a credit risk class problem in which I analyze “fair” deposit insurance premiums for two banks which are identical except for the degree of financial leverage. I also build a spreadsheet from scratch, which will help a lot when you work on this problem set.