ABSTRACT
This chapter explores the issue of how to measure the distance to default in deterministic and stochastic model variants. Employing the basic elements in the construction of the leveraging-asset price interaction has one dynamic decision variable (investment), but also exhibits two state equations: the dynamics of capital assets and the dynamics of debt. Here, then, borrowing and the evolution of debt are driving asset prices and rising asset prices may feed back into borrowing. Investment and commercial banks, private investors and mortgage buyers have faced, since 2000, exceptional funding conditions, not only concerning low interest rates, but because of over-optimism and under-estimation of risk. Thus, they also pay low credit spreads for the riskier borrowing. The expected pay-off of one firm is validated through credit expansions and expenditures by other firms and households. This can continue for a considerable time period and a credit expansion might even go on without collateral-secured loans, or without margin payment at all.
