CHAPTER 6
Idiosyncratic Risk,
Systematic Risk and
Stochastic Volatility: An
Implementation of
Merton’s Credit Risk
Valuation
Hayette Gatfaoui∗
6.1 INTRODUCTION
Originally Sharpe (1963) stated the dependence of stock returns vis-à-vis
systematic (for example, market or undiversifiable) risk and idiosyncratic
(for example, specific or diversifiable) risk. Indeed, systematic risk is com-
mon to any risky asset in the financial market whereas idiosyncratic risk is
peculiar to the asset under consideration. Therefore, credit risky assets, such
as corporate bonds or debt, should satisfy such a dependence feature. Many
∗I would like to thank participants at the International AFFI conference (Cergy, France, June
2004) and Deloitte Risk Management Conference (Antwerp, Belgium, May 2005). I also thank
Professors J.-P. Chateau and J. Wu (ESC Rouen) for their remarks. The usual disclaimer applies.
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