Modeling liquidation risk with occupation times
In this paper, we develop a new structural model that allows for a distinction between default and liquidation to be made. Default occurs when firm’s asset value process crosses a bankruptcy barrier. Here, we do not assume that default immediately triggers liquidation. Instead, the firm is allowed to continue operating even if it is in default. Liquidation is triggered as soon as the firm’s asset value has cumulatively spent a prespecified amount of time below the default barrier or has dropped below the liquidation barrier. The proposed model includes the Black–Cox model as a limiting case. A semi-analytical formula of the liquidation probability is derived for the case where firm’s asset value follows a geometric Brownian motion. Nonlinear volatility diffusion models are discussed as well.