From Default Distribution to Loss Distribution: Vasicek Mertonization

The Vasicek-Merton (VM) loss distribution function was derived using the Vasicek and the Merton models as an alternative to the AIRB approach. A loan was modeled as a portfolio of a risk-free bond, and a weighted combination of short European vanilla and binary put options written on the assets of the firm, with the strike equal to its debt and expiration equal to maturity of the loan. An endogenous Loss Given Default (LGD) was derived on the base of the Vasicek-Merton CDF.