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 Credit Risk

Modelling credit risk accurately is central to the practice of mathematical finance.

The majority of available texts are aimed at an advanced level, and are more suitable
for PhD students and researchers. This volume of the Mastering Mathematical Finance
series addresses the need for a course intended for master’s students, final-year
undergraduates, and practitioners. The book focuses on the two mainstream modelling
approaches to credit risk, namely structural models and reduced-form models, and on
pricing selected credit risk derivatives. Balancing rigorous theory with examples, it
takes readers through a natural development of mathematical ideas and financial
intuition.

m a r e k c a p i ń s k i is Professor of Applied Mathematics at AGH University of

Science and Technology, Kraków. His research interests include mathematical finance,
corporate finance, and hydrodynamics. He has been teaching for over 35 years, has
held visiting fellowships in Poland and the UK, and has published over fifty research
papers and nine books.

to m a s z z a s taw n i a k is Chair in Mathematical Finance at the University of

York. His research interests include mathematical finance, stochastic analysis,
stochastic optimisation and convex analysis, and mathematical physics. He has
previously taught at numerous institutions in Poland, the USA, Canada, and the UK,
and has published over fifty research publications and eight books.
Mastering Mathematical Finance

Mastering Mathematical Finance is a series of short books that cover all

core topics and the most common electives offered in Master’s programmes
in mathematical or quantitative finance. The books are closely coordinated
and largely self-contained, and can be used efficiently in combination but
also individually.
The MMF books start financially from scratch and mathematically assume
only undergraduate calculus, linear algebra, and elementary probability
theory. The necessary mathematics is developed rigorously, with emphasis
on a natural development of mathematical ideas and financial intuition, and
the readers quickly see real-life financial applications, both for motivation
and as the ultimate end for the theory. All books are written for both
teaching and self-study, with worked examples, exercises, and solutions.
[DMFM] Discrete Models of Financial Markets,
Marek Capiński, Ekkehard Kopp
[PF] Probability for Finance,
Ekkehard Kopp, Jan Malczak, Tomasz Zastawniak
[SCF] Stochastic Calculus for Finance,
Marek Capiński, Ekkehard Kopp, Janusz Traple
[BSM] The Black–Scholes Model,
Marek Capiński, Ekkehard Kopp
[PTRM] Portfolio Theory and Risk Management,
Maciej J. Capiński, Ekkehard Kopp
[NMFC] Numerical Methods in Finance with C++,
Maciej J. Capiński, Tomasz Zastawniak
[SIR] Stochastic Interest Rates,
Daragh McInerney, Tomasz Zastawniak
[CR] Credit Risk,
Marek Capiński, Tomasz Zastawniak
[SCAF] Stochastic Control Applied to Finance,
Szymon Peszat, Tomasz Zastawniak

Series editors Marek Capiński, AGH University of Science and Technol-

ogy, Kraków; Ekkehard Kopp, University of Hull; Tomasz Zastawniak,
University of York
Credit Risk

M A R E K C A P I Ń S K I
AGH University of Science and Technology, Kraków

TO M A S Z Z A S TAWN I A K
University of York
 University Printing House, Cambridge CB2 8BS, United Kingdom
One Liberty Plaza, 20th Floor, New York, NY 10006, USA
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Cambridge University Press is part of the University of Cambridge.

It furthers the University’s mission by disseminating knowledge in the pursuit of
education, learning, and research at the highest international levels of excellence.

www.cambridge.org
Information on this title: www.cambridge.org/9781107002760
10.1017/9781139047432
© Marek Capiński and Tomasz Zastawniak 2017
This publication is in copyright. Subject to statutory exception
and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without the written
permission of Cambridge University Press.
First published 2017
Printed in the United Kingdom by Clays, St Ives plc
A catalogue record for this publication is available from the British Library
ISBN 978-1-107-00276-0 Hardback
ISBN 978-0-521-17575-3 Paperback
Additional resources for this publication at www.cambridge.org/creditrisk.
Cambridge University Press has no responsibility for the persistence or accuracy of
URLs for external or third-party Internet Web sites referred to in this publication
and does not guarantee that any content on such Web sites is, or will remain,
accurate or appropriate.
Contents
Preface page vii
1 Structural models 1
1.1 Traded assets 1
1.2 Merton model 7
1.3 Non-tradeable assets 21
1.4 Barrier model 24
2 Hazard function model and no arbitrage 39
2.1 Market model 39
2.2 Default time and hazard function 41
2.3 Default indicator process 48
2.4 No arbitrage and risk-neutral probability 57
3 Defaultable bond pricing with hazard function 71
3.1 Initial prices and calibration 73
3.2 Process of prices 76
3.3 Recovery schemes 79
3.4 Martingale properties 81
3.5 Martingale properties of integrals 86
3.6 Bond price dynamics 91
4 Security pricing with hazard function 94
4.1 Martingale representation theorem 94
4.2 Pricing defaultable securities 96
4.3 Credit Default Swap 109
5 Hazard process model 114
5.1 Market model and risk-neutral probability 114
5.2 Martingales with respect to the enlarged filtration 116
5.3 Hazard process 121
5.4 Canonical construction of default time 125
5.5 Conditional expectations 130
5.6 Martingale properties 136
6 Security pricing with hazard process 146
6.1 Bond price dynamics 146
6.2 Trading strategies 150

v
vi Contents
6.3 Zero-recovery securities 157
6.4 Martingale representation theorem 162
6.5 Securities with positive recovery 169
A Appendix 176
A.1 Lebesgue–Stieltjes integral 176
A.2 Passage time and minimum of Wiener process 181
A.3 Stochastic calculus with martingales 185
Select bibliography 191
Index 193
Preface
Credit risk is concerned with the possibility of bankruptcy happening as
a result of unpaid debt obligations. This applies to companies partially fi-
nanced by debt. The key question is to find the value of debt or, equiv-
alently, the amount of interest charged by the debt holders to offset their
possible loss due to bankruptcy. Our goal is to explain the main issues in
the simplest possible cases, to keep the theory free of technical complica-
tions.
The first approach covered in this book relates bankruptcy to the com-
pany’s performance. The resulting model is referred to as structural. His-
torically, this was the first systematic approach to credit risk, developed by
Merton in 1974.
In the other method studied here, called the reduced-form approach, de-
fault occurs as a result of external forces, not related directly to the func-
tioning of the company, and comes as a surprise at a random time. This
may be the time when some information is revealed about technological
advances, court decisions, or political events, which could wipe out the
company.
We develop an approach similar to the classical financial theories, where
certain underlying securities are specified and self-financing strategies are
constructed from these. Here it is the risk-free and defaultable zero-coupon
bonds that will serve as underlying assets. This makes it possible to price a
range of defaultable securities, including Credit Default Swaps, by means
of replication. Then, after adding a Black–Scholes stock as a building block
of the market, the range of securities broadens, and this allows us to con-
clude with an example where the structural and reduced-form approaches
come together.
Readers of the book need to be familiar with material covered in some
earlier volumes in this series, namely [SCF] and [BSM], that is, with the
foundations of stochastic calculus and the Black–Scholes model. Exposure
to measure theory based probability, covered in [PF], would also be helpful.
The text is interspersed with various examples and exercises. The nu-
merical work underpinning many of the examples, and solutions to the ex-
ercises, are available at www.cambridge.org/creditrisk.

vii
1
Structural models

1.1 Traded assets

1.2 Merton model
1.3 Non-tradeable assets
1.4 Barrier model

Consider a company launched at time 0, when some assets are purchased

for V(0). Funding comes from two sources. Shareholders contribute E(0),
referred to as equity. The remaining amount D(0) = V(0) − E(0), called
debt, is either borrowed from a bank or raised by selling bonds issued by
the company.
We consider this company over a time interval from 0 to T, during which
the assets are put to work in order to generate some funds, which are then
split between the two groups of investors at time T . The debt is first repaid
with interest to the debt holders, who have priority over the equity holders.
Any remaining amount goes to the equity holders.
The simplest way to raise money to make these payments is to sell the
assets of the company. We begin our analysis with this case, by making the
necessary assumption that the assets are tradeable.

1.1 Traded assets

We assume that there is a liquid market for the assets, and V(t) for t ∈
[0, T ] represents their market value. We also assume that the assets generate
no additional cash flows. A practical example of such assets would be a
portfolio of traded stocks that pay no dividends, the company being an
investment fund.

1
2 Structural models
Payoffs
Suppose that the company has to clear the debt at time T , and that there are
no intermediate cash flows to the debt holders. The interest rate applying
to the loan will be quoted by the bank or implied by the bond price. We
denote this loan rate by kD with continuous compounding, and by KD with
annual compounding. The amount due at time T is

F = D(0)ekD T = D(0)(1 + KD )T .

(Throughout this volume we take one year as the unit of time.) One of the
goals here is to find the loan rate that reflects the risk for the debt holders.
At time T we sell the assets and close down the business, at least hy-
pothetically, to analyse the company’s financial position at that time. It is
possible that the amount obtained by selling the assets is insufficient to
settle the debt, that is, V(T ) < F. In this respect, we make an important
assumption concerning the legal status of the company: it has limited lia-
bility. This means that losses cannot exceed the initial equity value E(0).
If V(T ) < F, the equity holders do not have to cover the loss from their
personal funds. The company is declared bankrupt, and the equity holders
walk away having lost their initial investment. If V(T ) ≥ F, the loan can be
paid back with interest, and the equity holders keep the balance. The final
value of equity is therefore a random amount equal to the payoff of a call
option,
E(T ) = max{V(T ) − F, 0},

with the value of the assets as the underlying security and the debt repay-
ment amount F as the strike price.

Remark 1.1
A call is an option to buy the underlying asset for a prescribed price, which
sounds paradoxical here. However, it is consistent with the general practice
that loans are secured on some assets. The borrower’s ownership rights in
the assets are restricted until the loan is repaid. The full rights (for instance,
to sell the asset) are in a sense bought back when the loan is settled.

If V(T ) ≥ F, the debt will be paid in full, but in the case of bankruptcy,
which will be declared if V(T ) < F, the debt holders are going to take over
the assets and sell them for V(T ). This is straightforward if the assets are
tradeable. The amount received at time T will be

D(T ) = min{F, V(T )} = F − max{F − V(T ), 0}.

 1.1 Traded assets 3
We immediately recognise the put payoff as one of the components,

P(T ) = max{F − V(T ), 0}.

It reflects the limited liability feature.

Observe that

D(T ) + E(T ) = min{F, V(T )} + max{V(T ) − F, 0} = V(T ).

This is similar to the equality V(0) = D(0) + E(0), which holds at time 0,
and is called the balance sheet equation. It illustrates one of the basic
rules of corporate finance: the assets are equal to the liabilities (debt plus
equity).
If the payoff of the put option is identically zero (which is possible, for
example in the binomial model when the strike price is low enough), then
D(T ) = F and the debt position is risk free. In this case, we should have
kD = r, the continuously compounded risk-free rate. If it is possible that
the debt holders recover less than F, a higher rate kD will be applied to
compensate for the risk.
These remarks motivate the following proposition, which does not de-
pend on any particular model for the asset value process. Let P(0) denote
the time 0 price of the put option.

Proposition 1.2
If P(0) > 0, then kD > r.

Proof Recall the put-call parity relationship expressed in terms of a call,

put, stock, and a general strike price K:

S (0) = C(0) − P(0) + Ke−rT .

In our case it becomes

V(0) = E(0) − P(0) + Fe−rT .

This implies that

D(0) = Fe−rT − P(0).

In other words,
F = [D(0) + P(0)] erT . (1.1)

Recall that F = D(0)ekD T , so

D(0)ekD T = [D(0) + P(0)] erT ,

4 Structural models
which yields
 
1 P(0)
kD = r + ln 1 +
T D(0)
and implies that kD > r as claimed since the second term on the right-hand
side is positive. 
As we can see, the loan rate kD is typically higher than the risk-free
rate r. This is consistent with intuition since the loan is not free of risk as
the full amount F is paid only in some circumstances.
Definition 1.3
The difference s = kD − r is called the credit spread.
This quantity represents the additional return demanded by the debt
holders to compensate for their exposure to default risk.
The positivity of the credit spread is all that can be discovered without
specifying a model for asset values. Such a model is needed to have a
method of computing option prices, and in turn solving the pivotal problem
of setting the level of F, hence kD , for a given debt and equity values E(0)
and D(0), which determine the financial structure of the company.
It is often convenient to describe the financial structure of the company
in terms of ratios rather than the actual debt and equity values.
Definition 1.4
The debt and equity ratios are defined as
D(0) E(0)
wD = , wE = .
V(0) V(0)
Because V(0) = D(0) + E(0), these ratios satisfy wE + wD = 1.
We have seen that equity can be regarded as a call option with strike F.
The time 0 price of this call option, which we now denote by C(F), satisfies
C(F) = E(0). This equation can be solved for F, and we illustrate this with
the simplest model.

Binomial model
Consider the single-step binomial model and suppose that V(T ) takes only
two values V(0)(1 + U) and V(0)(1 + D) determined by the returns −1 <
D < R < U, where R is the risk-free return, that is, 1 + R = erT . The
non-trivial range of strike prices is
V(0)(1 + D) < F < V(0)(1 + U),
 1.1 Traded assets 5
and then
1
E(0) = C(F) = q(V(0)(1 + U) − F),
1+R
where
R−D
q=
U−D
is the risk-neutral probability (see [DMFM]). The formula is justified by
the fact that the payoff of the call option can be replicated by means of V(T )
and the risk-free asset, both assumed tradeable. This gives us the corre-
sponding range of initial equity values
1
0 < E(0) < qV(0)(U − D).
1+R
The equation for F can be solved to get
1
F = V(0)(1 + U) − E(0)(1 + R),
q
and then
F
ekD T = (1 + KD )T = .
D(0)
The investors are interested in real-life probabilities to evaluate their
prospects, and these should be used to find the expected returns and stan-
dard deviations of returns for equity and debt. The computations are straight-
forward, and we simply consider a numerical example.

Example 1.5
Let V(0) = 100, T = 1, R = 20%, U = 40%, and D = −40%, hence
q = 0.75. With E(0) = 40 we find F = 76 and KD = 26.67%. Assuming
the real-life probability of the up movement to be p = 0.9, we get the
expected return on assets to be μV = 32%, the expected return on equity
μE = 44%, and on debt μD = 24%. The last figure is important for the
debt holders as it will be earned on average if the loan rate KD is quoted
for all similar customers. The standard deviation of the return on debt is
σD = 8%.
If equity is reduced to E(0) = 20, we have F = 108, KD = 35%, and the
expected return on debt under the real-life probability grows to 29% while
the standard deviation of the return on debt becomes 18%.
In the extreme (and unrealistic) case of E(0) = 50 we have KD = R
and the expected return is the same, the risk being zero (the debt payoff
6 Structural models

is F in each scenario). In the other extreme case of E(0) = 0 the company

is owned entirely by the debt holders, the parameters for debt coinciding
with those for the assets.
Since the payoff for equity is an affine function of V(T ), the expected
return on equity is the same for each level of financing, μE = 44%. The
model is not sophisticated enough to see anything interesting here.

Remark 1.6
In the single-step binomial model the balance between the expected re-
turn μH and standard deviation σH of return of any derivative security H
(in particular H = V, E, or D) is captured by the fact that the market price
of risk μσH −R
H
is the same for each H; see [DMFM].

For two steps the situation becomes more interesting. There are three
possible values of V(T ) and larger scope for non-trivial cases. The range
for the strike price is

V(0)(1 + D)2 < F < V(0)(1 + U)2 .

The pricing formula and, in particular, the equation for F become more
complicated. Once again, we just analyse a numerical example.

Example 1.7
Using the data from Example 1.5, we perform computations for two cases,
E(0) = 40 and E(0) = 60. We find the respective values of F to be 93.60
and 59.04, the expected two-period returns on equity 107.36% and 92.38%,
and the corresponding standard deviations 100.43% and 74.20%. The cor-
responding expected returns on debt are 52.16% and 47.02% (as compared
with the risk-free return of 44%), with standard deviations 11.11% and
5.73%, respectively.

Exercise 1.1 Derive an explicit general formula for F in the two-

step binomial model, and compute the expected return and standard
deviation of the return for equity and debt as in Example 1.7 in the
case of 50% financing by equity.
 1.2 Merton model 7
Rather than considering the n-step binomial model and using the Cox–
Ross–Rubinstein (CRR) formula for the call price (see [DMFM]), which is
similar to the Black–Scholes formula, we proceed directly to the latter as it
is important and in fact easier to handle.

1.2 Merton model

Suppose that the assets of a company are tradeable and follow the Black–
Scholes model, i.e. satisfy the stochastic differential equation
dV(t) = μV(t)dt + σV(t)dWP (t),
where WP (t) is a Wiener process under the real-life probability P. Gir-
sanov’s theorem (see [BSM]) makes it possible to change to the risk-neutral
probability Q and write the stochastic differential equation as
dV(t) = rV(t)dt + σV(t)dWQ (t),
where WQ is a Wiener process under Q.
Let us put
C(V(0), σ, r, T, F) = V(0)N(d+ ) − e−rT FN(d− ),
where
ln V(0) + (r + 12 σ2 )T ln V(0) + (r − 12 σ2 )T
d+ = F
√ , d− = F
√ , (1.2)
σ T σ T
and where  x
1 1 2
N(x) = √ e 2 y dy
−∞ 2π
is the standard normal cumulative distribution function. We recognise the
expression defining C(V(0), σ, r, T, F) as the Black–Scholes call pricing
formula; see [BSM].
We have E(0) = C(V(0), σ, r, T, F) since equity is a call option with
strike F. This can be written as
E(0) = V(0)N(d+ ) − e−rT FN(d− ).
The equation needs to be solved for F numerically, with V(0), σ, r, and T
fixed. (When solving the equation, remember that d+ and d− also depend
on F.) The formula for the initial value of debt reads
D(0) = V(0)N(−d+ ) + e−rT FN(d− ).
8 Structural models
This follows from the balance sheet equation V(0) = E(0) + D(0) and the
symmetry 1 − N(x) = N(−x) of the standard normal distribution. Together,
these are the ingredients of Merton’s model of credit risk.

Example 1.8
Let V(0) = 100 and consider 50% financing by equity. Assume the risk-
free rate r = 5% and volatility σ = 30%, and take T = 1. We can solve the
equation
C(V(0), σ, r, T, F) = 50
to find F = 52.6432, and then compute the loan rate
1 F
kD = ln = 5.1515%,
T D(0)
KD = ekD − 1 = 5.2865%.

Exercise 1.2 Within the setup of Example 1.8 consider an invest-

ment in stock with volatility higher than 30%. What does your in-
tuition say about the impact of this on kD ? Analyse the monotonic-
ity of kD as a function of σ. Perform numerical computations for
σ = 35%.

Expected returns
It is interesting to find the expected returns on equity and debt between the
time instants 0 and T under the real-life probability P and analyse their
dependence on the financial structure. To this end we need to compute the
expectation EP (E(T )) under the real-life probability. The Black–Scholes
formula gives a similar expectation but under the risk-neutral probability,

EQ (E(T )) = EQ ((V(T ) − F)+ ) = erT C(V(0), σ, r, T, F),

where
  
1
V(T ) = V(0) exp r − σ2 T + σWQ (T ) .
2
 1.2 Merton model 9
This formula is valid for every r > 0, in particular for r = μ. On the other
hand, we also have
  
1 2
V(T ) = V(0) exp μ − σ T + σWP (T ) .
2
Because WQ (T ) has the same probability distribution under the risk-neutral
probability Q as WP (T ) under the real-life probability P (namely the nor-
mal distribution N(0, T )), it follows that
EP (E(T )) = EP ((V(T ) − F)+ ) = eμT C(V(0), σ, μ, T, F).
This enables us to compute the expected return on equity under the real-life
probability,
EP (E(T )) − E(0)
μE = .
E(0)
To find the expected return on debt μD we can use the relationship
μV = w E μ E + w D μ D
from portfolio theory (see [PTRM]), with μV = eμT − 1 since EP (V(T )) =
V(0)eμT .

Example 1.9
For the data from Example 1.8 and μ = 10% we get μV = 10.52%, μE =
15.85%, and μD = 5.19%.

Exercise 1.3 Using the data in Example 1.8 and μ = 10%, com-
pute F and μE , μD for a company with 40% financing by equity, and
also for one with 60% financing by equity.

Example 1.10
For the data in Example 1.8 and μ = 10%, in Figure 1.1 we plot the graphs
of the expected returns μE and μD as functions of the equity ratio wE . For
comparison, we include the expected return μV = eμT − 1 on the assets,
independent of financing, thus a horizontal line.
10 Structural models

Figure 1.1 Expected returns μV , μE , μD as functions of equity ratio wE .

High level of debt is profitable for equity holders, and it also appears at-
tractive to debt holders. However, in real life the amount of debt recovered
following bankruptcy will be reduced by legal costs. In addition, rapid liq-
uidation of a large number of assets may reduce the prices. These factors
affect the debt payoff and hence the expected return on debt μD , computed
above assuming full recovery.

Partial recovery
We are going to discuss the case when the market value of the company’s
assets cannot be fully recovered due to the cost of bankruptcy procedures.
It is not possible to use the relationship μV = wD μD + wE μE from portfolio
theory because additional participants emerge in the case of bankruptcy,
such as bailiffs or legal services providers.
Suppose that the amount recovered by debt holders is proportional to
the value of the assets. When default occurs, that is, when V(T ) < F,
bankruptcy procedures are initiated, the assets are sold, and the debt hold-
ers receive αV(T ), where α ∈ [0, 1] is a constant recovery rate. Otherwise,
when V(T ) ≥ F, the company remains solvent and able to settle the debt in
full. As a result, the debt payoff becomes
D(T ) = F1{V(T )≥F} + αV(T )1{V(T )<F} .
When α < 1 the debt holders’ payoff αV(T ) in the case of bankruptcy
is reduced as compared to the full recovery payoff V(T ) in the case with
α = 1. To be compensated for this reduction, the debt holders will demand
 1.2 Merton model 11
a higher loan rate kD , that is, a higher amount F = D(0)ekD T due at ma-
turity if there is no default (the sum borrowed, D(0), remains unchanged).
This amount F can be found by expressing the time 0 value of debt as
the discounted expectation of the debt payoff D(T ) under the risk-neutral
probability Q, which we denote by
D(V(0), σ, r, T, F) = e−rT EQ (D(T )),
and by solving the equation
D(0) = D(V(0), σ, r, T, F) (1.3)
for F. For better clarity we denote the solution by Fα , so the above equation
becomes
D(0) = e−rT EQ (Fα 1{V(T )≥Fα } + αV(T )1{V(T )<Fα } ).
The formula for equity payoff is, as before, that of a call option, with
modified strike Fα . Namely,
E(T ) = max {V(T ) − Fα , 0} .
The value of this payoff is reduced due to the fact that the strike will be set
higher in the case of partial recovery as compared to full recovery. Initially,
the company is financed by an amount E(0) from equity holders and by
debt D(0). As soon as the company is set up at time 0 by entering into a
debt agreement and investing the total V(0) = E(0) + D(0) into the assets,
the value of equity drops down to a new level
Eα (0) = e−rT EQ (E(T )) = C(V(0), σ, r, T, Fα ),
which is lower than the invested amount E(0). Indeed, the difference is
E(0) − Eα (0) = V(0) − D(0) − e−rT EQ (max {V(T ) − Fα , 0})
= e−rT EQ (V(T ) − D(T ) − max {V(T ) − Fα , 0})
= e−rT EQ (V(T ) − Fα 1{V(T )≥Fα } − αV(T )1{V(T )<Fα }
− (V(T ) − Fα ) 1{V(T )≥Fα } )
= e−rT EQ ((1 − α)V(T )1{V(T )<Fα } ) ≥ 0.
We recognise (1 − α)V(T )1{V(T )<Fα } as the cost of liquidating the company
in the case of a default. Note that V(0) > Eα (0) + D(0).
To compute Fα we need to derive a formula for D(V(0), σ, r, T, Fα ) and
then solve equation (1.3). It is not difficult to compute the expectation
EQ (D(T )) = Fα Q(V(T ) ≥ Fα ) + αEQ (V(T )1{V(T )<Fα } ).
12 Structural models
Writing
√
V(T ) = V(0)e(r− 2 σ )T +σ
1 2
TX
,

where X follows the standard normal distribution N(0, 1) under Q, we have

Q(V(T ) ≥ Fα ) = Q(−X ≤ d− ),
   √ 
EQ V(T )1{V(T )<Fα } = V(0)EQ e(r− 2 σ )T +σ T X 1{X<−d− } ,
1 2

with d− given by (1.2) with Fα replacing F. Next

Q(V(T ) ≥ Fα ) = N(d− ),
 −d−
  1 1 2 √
EQ V(T )1{V(T )<Fα } = V(0)e(r− 2 σ )T √ e 2 x eσ T x dx.
1 2

−∞ 2π
The integral can be evaluated in a similar way as in the derivation of the
Black–Scholes formula. For the convenience of the reader we present the
calculations:
 −d− 
1 12 x2 σ √T x 1 12 σ2 T −d− − 12 (x−σ √T )2
√ e e dx = √ e e dx
−∞ 2π 2π −∞
 −d+
1 1 2
= √ e2σ T e− 2 y dy
1 2

2π −∞
σ T
1 2
=e 2 N(−d+ ),
√
where we use the substitution y = x − σ T , and where d+ is given by (1.2)
with Fα replacing F. As a result,

D(V(0), σ, r, T, Fα ) = e−rT Fα N(d− ) + αV(0)N(−d+ ).

We are ready to compute Fα by solving (1.3) numerically.

Example 1.11
For the data in Example 1.10, with debt and equity financing at wD = wE =
50%, we compute the final value Fα of debt at maturity and the correspond-
ing value of equity Eα (0) at time 0 for various values of the recovery rate α
ranging from 0.5 to 1.
α 0.5 0.6 0.7 0.8 0.9 1.0
Fα 53.0465 52.9611 52.8782 52.7977 52.7194 52.6432
Eα (0) 49.6225 49.7025 49.7801 49.8554 49.9287 50.0000
 1.2 Merton model 13
Risk
We proceed to the task of computing the standard deviations of the returns
on equity and debt to gain some additional insight.
We begin with computing the expected squared equity payoff

EP (E(T )2 ) = EP (((V(T ) − F)+ )2 )

= EP (1{V(T )≥F} (V 2 (T ) − 2V(T )F + F 2 ))
 ∞ √
1
= V(0)2 e2(μ− 2 σ )T √ e− 2 x e2σ T x dx
1 2 1 2

d 2π
 ∞ √
1
− 2FV(0)e(μ− 2 σ )T √ e− 2 x eσ T x dx + F 2 (1 − N(d)).
1 2 1 2

d 2π

Next, similar to before, we evaluate the integral

 ∞ √
 ∞ √
1 1
√ e− 2 x e2σ T x dx = √ e− 2 (x −4σ T x+4σ T ) e2σ T dx
1 2 1 2 2 2

d 2π 2π d
 ∞ √ 2
2σ2 T 1
e− 2 (x−2σ T ) dx
1
=e √
2π d
 ∞
2 1 − 12 y2
=e 2σ T
√ √ e dy
2π d−2σ T
2 √
= e2σ T (1 − N(d − 2σ T )),
√
where we make the substitution y = x − 2σ T . Hence, replacing 2σ by σ,
we get
 ∞ √ √
1
√ e− 2 x eσ T x dx = e 2 σ T (1 − N(d − σ T )).
1 2 1 2

d 2π

These formulae give the standard deviation of the return on equity

⎛ ⎞
⎜⎜⎜ E(T ) − E(0) 2 ⎟⎟⎟
σ2E = EP ⎝⎜ ⎟⎠ − μ2E
E(0)
EP (E(T )2 ) 2EP (E(T ))
= − + 1 − μ2E ,
E(0)2 E(0)

where EP (E(T )) = E(0)(1 + μE ) with μE computed as before.

For debt we work along similar lines and assume full recovery. First we
14 Structural models
find
EP (D(T )2 ) = EP (min{V(T ), F}2 )
= EP (1{V(T )<F} V 2 (T )) + F 2 P(V(T ) ≥ F)
 d √
1
= V(0)2 e2(μ− 2 σ )T √ e− 2 x e2σ T x dx + F 2 (1 − N(d))
1 2 1 2

−∞ 2π
2 2(μ− 12 σ2 )T 2σ2 T
√
= V(0) e e N(d − 2σ T ) + F 2 (1 − N(d)).
This allows us to compute the standard deviation of the return on debt as
⎛ ⎞
⎜⎜ D(T ) − D(0) 2 ⎟⎟⎟
σ2D = EP ⎜⎜⎝ ⎟⎠ − μ2D
D(0)
EP (D(T )2 ) 2EP (D(T ))
= − + 1 − μ2D ,
D(0)2 D(0)
where EP (D(T )) = D(0)(1 + μD ) with μD computed as before.

Example 1.12
With the data from Example 1.9 we obtain σE = 67.65% and σD = 1.29%.

Exercise 1.4 Compute σE and σD for the data in Example 1.9 but
with 40% and 60% financing by equity.

Exercise 1.5 Compute the correlation coefficient ρED between the

returns on debt and equity by using the formula
σ2V = w2E σ2E + w2D σ2D + 2wE wD σE σE ρED
from portfolio theory (see [PTRM]), for various levels of debt, within
the data of Example 1.9.

Example 1.13
Figure 1.2 shows the dependence of σD and σE on the financing structure of
the company as represented by the equity ratio wE . The graphs use the same
 1.2 Merton model 15

Figure 1.2 Standard deviations σE and σD as functions of equity ratio wE .

numerical data as in Example 1.12. If wE = 1, we have σE = σV = 33.92%

and σD is undefined. If wE = 0, then σD = σV and σE makes no sense. The
risk for equity is very high for equity financing below 50%, while the risk
for the debt holders is also substantial in this region.

Example 1.14
High risk may be acceptable if it is accompanied by high expected return.
The relationship between return and risk is captured by the market price
of risk, which is a convenient way to quantify the additional return over
and above the risk-free return to compensate for risk. It is given by μσE −R
E

and μσD −R
D
for equity and debt, where 1 + R = erT
. Maximising the market
price of risk is a possible goal for the investors. In the case considered in
the above examples, the market price of risk grows with the corresponding
ratio:
wE 0.1 0.2 0.3 0.4 0.5 0.6 0.7
μE −R
σE 12.30% 14.31% 15.24% 15.68% 15.85% 15.89% 15.89%
wD 0.9 0.8 0.7 0.6 0.5 0.4 0.3
μD −R
σD 15.63% 13.68% 11.05% 7.94% 4.68% 1.95% 0.42%

The point where this quantity is the same for both participants may be
regarded as an equilibrium of some kind. In the case in hand this takes
place at wD = 0.8172, a debt ratio which may be rejected by a conservative
16 Structural models

debt holder. This would correspond to a risky bond with a high return and
high probability of default, a so-called junk bond.

Remark 1.15
When a company’s income is taxed, interest on debt is a tax-deductible
expense. This is an advantage for equity holders, called a tax shield, but
it makes the analysis more complicated. If tax is charged at a rate Rtax on
the difference between the company’s income V(T ) − V(0) and the interest
F − D(0) whenever the resulting difference is positive, then equity holders
will be left with the payoff
E(T ) = (V(T ) − Rtax (V(T ) − V(0) − F + D(0))+ − F)+ ,
after the debt and tax are settled. In particular, they walk away with nothing
if the company’s value V(T ) turns out to be insufficient to pay both the debt
and the tax.

Credit spread
In the literature on credit risk the financial structure of a company is often
described in terms of a ratio related to F, the amount due, rather than to the
initial debt value D(0). This is in line with the point of view that F is the
principal parameter. Compared with Definition 1.4, in the formula below
D(0) is replaced by the present value of F computed using the risk-free
rate. The result is an abstract quantity, which nonetheless becomes a handy
tool when analysing the credit spread.

Definition 1.16
The quasi debt ratio is defined as
Fe−rT
l= .
V(0)
Note that wD < l since kD > r. The role of l can be seen if we use the
Black–Scholes formula to compute the credit spread.

Proposition 1.17
The credit spread is given by
 
1 N(−d+ )
s=− ln + N(d− ) ,
T l
 1.2 Merton model 17
where d+ , d− are as in (1.2). To highlight the dependence on l we write the
expressions for d+ , d− as

− ln l + 12 σ2 T − ln l − 12 σ2 T
d+ = √ , d− = √ .
σ T σ T
Proof In the proof of Proposition 1.2, formula (1.1), we saw that

D(0) = Fe−rT − P(0),

where P(0) is the price of a put option with strike F and expiry time T
written on the company value V(T ). Recall the Black–Scholes formula for
the put price (see [BSM])

P(0) = −V(0)N(−d+ ) + Fe−rT N(−d− ).

It follows that
 
1 F
s = kD − r = ln −r
T D(0)
   −rT 
1 D(0) 1 Fe − P(0)
= − ln = − ln
T Fe−rT T Fe−rT
 
1 −V(0)N(−d+ ) + Fe−rT N(−d− )
= − ln 1 −
T Fe−rT
 
1 N(−d+ )
= − ln 1 + − N(−d− ) .
T l
To conclude, it is sufficient to note that 1 − N(−d− ) = N(d− ). 

Example 1.18
Figure 1.3 shows the credit spread term structure (i.e. s as a function of
debt maturity T ) for σ = 30% and for various levels of the quasi debt ratio,
from l = 0.5 to 1.1. We can see that the credit spread converges to zero as
T  0 when l < 1 and to ∞ when l ≥ 1. This fact can be proved.

Proposition 1.19
Write
 
1 N(−d+ (T ))
s(T ) = − ln + N(d− (T ))
T l
18 Structural models

Figure 1.3 Credit spread term structure in Merton’s model for various quasi
debt ratios l.

with
− ln l + 12 σ2 T − ln l − 12 σ2 T
d+ (T ) = √ , d− (T ) = √ .
σ T σ T

Then

0 when l < 1,
lim s(T ) =
T 0 ∞ when l ≥ 1.

Proof Let us consider the case when l < 1. Then

− ln l + 12 σ2 T
lim d+ (T ) = lim √ = ∞,
T 0 T 0 σ T
− ln l − 12 σ2 T
lim d− (T ) = lim √ = ∞.
T 0 T 0 σ T

As a result,
 
1 1
lim N(−d+ (T )) + N(d− (T )) = lim N(−x) + lim N(x) = 1
T 0 l l x→∞ x→∞

and
 
1
lim ln N(−d+ (T )) + N(d− (T )) = 0.
T 0 l
 1.2 Merton model 19
It follows that we can apply l’Hôpital’s rule to compute the limit
 
d
dT
ln 1l N(−d+ (T )) + N(d− (T ))
lim s(T ) = − lim d
T 0 T 0 (T )
 dT

d 1
dT l
N(−d+ (T )) + N(d− (T ))
= − lim 1
T 0
l
N(−d+ (T )) + N(d− (T ))
1 d d
= − lim (N(−d+ (T ))) − lim (N(d− (T )))
l T 0 dT T 0 dT
1 2 d 1 2 d
= √ lim e− 2 d+ (T ) (d+ (T )) − √ lim e− 2 d− (T )
1 1
(d− (T ))
l 2π T 0 dT 2π T 0 dT
=0

since the exponentials e− 2 d+ (T ) and e− 2 d− (T ) converge to zero faster than

1 2 1 2

the derivatives
d T σ2 + 2 ln l d T σ2 − 2 ln l
(d+ (T )) = , (d− (T )) = −
4T 2 σ 4T 2 σ
3 3
dT dT
converge to ∞ or −∞ as T  0.
The case when l ≥ 1 is covered in Exercise 1.6. 

Exercise 1.6 Complete the proof of Proposition 1.19 for l ≥ 1.

Remark 1.20
The fact that in the economically realistic case when l < 1 the credit
spread s vanishes in the short term is regarded as a major drawback of
Merton’s structural model. It is inconsistent with empirical studies, which
show that the model underestimates such spreads.

Fixed assets
The assumption that all assets are traded is unrealistic for a typical com-
pany. In Section 1.3 we are going to relax it, while here we present a ver-
sion pointing in this direction. We are going to modify the previous model,
where the company’s activity is based on trading stock, by including some
fixed assets needed to run the company, such as office equipment, comput-
ers, and the like. These fixed assets are not actively traded, but have market
value, which we denote by L and assume to be constant for simplicity. In
20 Structural models
the case of a shortage of funds they can be sold to settle the obligations.
Therefore we have
V(t) = L + S (t),
where S (t) is the tradeable asset (stock) price, which follows the log-normal
process
dS (t) = rS (t)dt + σS (t)dWQ (t).
The company is financed by equity and debt as before,
V(0) = E(0) + D(0),
and we seek F = D(0)ekD T for a given debt level D(0). The equity and debt
payoffs at time T are as follows:
• If S (T ) ≥ F, then debt is fully settled, D(T ) = F, the fixed assets remain
intact, and the value of equity becomes E(T ) = L + S (T ) − F.
• If S (T ) < F and L + S (T ) ≥ F, then D(T ) = F. All traded assets
and some of the fixed assets have to be sold. The equity value E(T ) =
L + S (T ) − F is what remains of the fixed assets.
• If L + S (T ) < F, then D(T ) = L + S (T ) and E(T ) = 0. All assets are sold
and bankruptcy is declared.
It means that equity is a call option on S (T ) with strike price F − L (rather
than on V(T ) with strike price F as before), whose payoff is
E(T ) = max{S (T ) − (F − L), 0},
while the debt payoff is
D(T ) = min{F, L + S (T )} = F − max{(F − L) − S (T ), 0}.
Clearly,
E(T ) + D(T ) = L + S (T ) = V(T ).
The value of F can be found by matching the given initial debt level D(0)
to the time 0 value of the debt payoff D(T ), that is,
D(0) = e−rT EQ (min{F, L + S (T )}).

Example 1.21
With the data from Example 1.9, take L = 5. For debt financing at wD =
70% we have μE = 20.89%, μD = 5.32%, and the credit spread is s =
1.54%.
 1.3 Non-tradeable assets 21

1.3 Non-tradeable assets

We move on to consider a company using specialised equipment or licences
which cannot be sold, in addition to fixed assets (office equipment, com-
puter hardware, etc.) which can. The investment in such a company is par-
tially irreversible.
At time 0 the assets are purchased for
V(0) = L + G(0),
where L is the value of the fixed assets and G(0) is the amount invested to
acquire the non-tradeable assets. The fixed assets are liquid and can be sold
for L at any time. This action may be necessary, in particular, to meet the
debt obligations of the company. The value G(0) is real as some licences
or specialised machinery are purchased at time 0. However, it will not be
possible to sell these assets, so their future value G(t) becomes nominal,
determined by the investors’ belief that the company will generate profits.
For this reason, the term goodwill is used when referring to G(t). Goodwill
is a valuable asset in its own right, and its dynamics will be modelled by a
log-normal process as
dG(t) = μG(t)dt + σG(t)dWP (t),
where WP (t) is a Wiener process under the real-life probability P.
The profit will be described by a process Π(t), starting from Π(0) = 0
and not necessarily positive. We make a simple assumption that increments
in goodwill are proportional to the increments in profits,
G(t) − G(0) = q(Π(t) − Π(0)).
This gives
G(t) = qΠ(t) + G(0).
In contrast to goodwill G(t), the profit Π(t) can be observed (or at least
predicted in the business plan), and this relationship between G(t) and Π(t)
makes it possible to calibrate the parameters μ, σ, q.
As before, the purchase of assets at time 0 is financed by equity and debt,
V(0) = E(0) + D(0).
The amount due to settle the debt at time T together with interest at a
rate kD (continuously compounded) is
F = ekD T D(0).
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Title: Married or single? Vol. 3 (of 3)

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*** START OF THE PROJECT GUTENBERG EBOOK MARRIED

OR SINGLE? VOL. 3 (OF 3) ***
MARRIED OR SINGLE?
 NEW NOVELS AT ALL LIBRARIES.
HEART OF OAK: A Three-Stranded Yarn. By W. Clark
Russell. 3 vols.
THE PROFESSOR’S EXPERIMENT. By Mrs. Hungerford. 3
vols.
THE WOMAN IN THE DARK. By F. W. Robinson. 2 vols.
THE VOICE OF THE CHARMER. By L. T. Meade. 3 vols.
SONS OF BELIAL. By William Westall. 2 vols.
LILITH. By George MacDonald. 1 vol.
LADY KILPATRICK. By Robert Buchanan. 1 vol.
CLARENCE. By Bret Harte. 1 vol.
THE IMPRESSIONS OF AUREOLE. A Diary of To-Day. 1 vol.
DAGONET ABROAD. By George R. Sims. 1 vol.
THE KING IN YELLOW. By Robert W. Chambers. 1 vol.
IN THE QUARTER. By Robert W. Chambers. 1 vol.
London: CHATTO & WINDUS, Piccadilly.
 MARRIED OR SINGLE?
BY
B. M. CROKER
AUTHOR OF
“DIANA BARRINGTON,” “A FAMILY LIKENESS,” ETC.

IN THREE VOLUMES
VOL. III.

LONDON
CHATTO & WINDUS, PICCADILLY
1895
 CONTENTS OF VOL. III.
CHAPTER PAGE
XXIX. “Mr. Wynne!” 1
XXX. Married or Single? 11
XXXI. A False Alarm 31
XXXII. Mr. Jessop’s Suggestion 55
XXXIII. “One of your Greatest Admirers” 65
XXXIV. Mr. Wynne is a Widower 83
XXXV. Information thankfully received 97
XXXVI. To meet the Shah-da-Shah 119
XXXVII. “Gone off in her White Shoes!” 134
XXXVIII. Death and Sickness 148
XXXIX. White Flowers 164
XL. A Forlorn Hope 178
XLI. “Laurence!” 199
XLII. Won Already 218
XLIII. Hearts are Trumps 238
MARRIED OR SINGLE?
 CHAPTER XXIX.
“MR. WYNNE!”

A few days before their departure for the sunny south, Miss West,
her father, and several visitors were sitting in the drawing-room, the
tall shaded lamps were lit, the fragrant five-o’clock cup was being
dispensed by Madeline; who was not, as Lady Rachel remarked, in
her usual good spirits. Lady Rachel had thrown off her furs, she had
secured a comfortable seat in a becoming light, and was flirting
audaciously with a congenial spirit. Mrs. Leach was of course
present, and an elderly colonel, Mrs. Veryphast (a smart society
matron), her sister, and a couple of Guardsmen—quite a gathering.
Mrs. Veryphast was laughing uproariously, Mrs. Leach was solemnly
comparing notes respecting dressmakers with Mrs. Veryphast’s
sister. The colonel, Mr. West, and Lord Tony, were discussing the
share list. The Guardsmen were devoting themselves to the fair tea-
maker, when the anteroom door was flung open with a flourish, and
a footman announced “Mr. Wynne!”
This name was merely that of an ordinary visitor—one of the
multitude who flocked to offer incense to his daughter, a partner and
a slave, in fact, in the ears of every one save two—Lord Tony’s, and
Mrs. Wynne’s. The latter felt as if she had been turned to stone. Had
Laurence come to make a scene? to claim her? She breathed hard,
living a whole year of anxiety in a few seconds of time. The hand that
held the sugar-tongs actually became rigid through fear. She glanced
at her father. He, poor innocent individual, was totally unconscious of
the crisis, and little supposed that the good-looking young fellow now
shaking hands with Madeline was actually his son-in-law!
“Oh, how do you do?” faltered Miss West, and raising a swift,
appealing, half-terrified look to the stranger. “Papa, let me introduce
Mr. Wynne.”
 Mr. Wynne bowed, uttered a few commonplaces to the invalid, and
stood talking to him for some time.
Meanwhile, Mr. West noticed with satisfaction the air of refinement
and of blue blood (which he adored) in the visitor’s appearance and
carriage. Wynne was a good name.
No one guessed at the situation, except Lord Tony. His breath was
taken away, he looked, he gaped, he repeated the same thing four
times over to Mrs. Veryphast—who began to think that this jovial little
nobleman was a fool. To see Miss West thus calmly (it looked so at a
distance) present her husband to her father, as he afterwards
expressed it, “completely floored him.” And the old chap, innocent as
an infant, and Wynne as cool as a cucumber, as self-possessed as it
was possible to be!
And then suddenly Lady Rachel turned round and saw him, and
called out in her shrill, clear voice, “Why, Mr. Wynne, is it possible!
who would have thought of seeing you here? Come over and sit
beside me,” making room on the Chesterfield couch, “and amuse
me.”
“I’m afraid I’m not a very amusing person,” he replied, accepting
her beringed fingers, and standing before her.
“You can be, if you like; but perhaps you now reserve all your witty
sayings for your stories. Are you writing anything at present?”
(Stereotyped question to author.)
“No, not at present,” rather stiffly.
“I did not know you knew the Wests. Maddie, dear,” raising her
voice, “you never told me that you and Mr. Wynne were
acquaintances.”
Madeline affected not to hear, and stooped to pick up the tea-cosy,
and hide a face which had grown haggard; whilst Mr. West, who had
gathered that Wynne was a rising man, and that his books were
getting talked about, invited him to come and sit near him, and tell
him if there was anything going on—anything in the evening papers?
 “You see, I’m still a bit of an invalid,” indicating a walking-stick;
“shaky on my pins, and not allowed to go to my club. I’ve had a very
sharp attack, and I’m only waiting till the weather is a little milder to
start for the south of France.” He had taken quite a fancy to this
Wynne (and he did not often fall in love at first sight).
Madeline looked on as she handed her husband a cup of tea, by
her parent’s orders, and was spellbound with amazement and
trepidation to see Laurence and her father, seated side by side,
amiably talking politics, both being, as it providentially happened, of
the same party. This was to her almost as startling a spectacle as if
an actual miracle had been performed in the drawing-room before
her eyes.
That her attention strayed in one particular direction did not
escape Mrs. Leach’s observation. Could this be——But no, he was
far too presentable, he was evidently one of the Wynnes of Rivals
Wynne; she herself saw the strong family likeness. He was
absolutely at his ease, he scarcely noticed Miss West, though she
glanced repeatedly at him, was looking pale and agitated, talked
extreme nonsense, and filled cups at random.
No, no; this man was not the mysterious friend. No such luck for
Madeline; and, if he had been, he never could have had the nerve to
walk boldly and alone into the very lion’s den. But he probably knew
the real Simon Pure, and was a go-between and messenger. Yes,
that was it. Having thus disposed of her question to her entire
satisfaction, and carefully studied Mr. Wynne, from the parting of his
hair to the buttons of his boots, she turned and exercised her
fascinations on the colonel, who was one of her sworn admirers.
Lady Rachel, who had wearied of her companion, threw him off
with an airy grace—which is one of the finest products of civilization
—and, on pretence of having a little talk with Mr. West, cleverly
managed to monopolize Mr. West’s companion, chatting away most
volubly—though now and then Mr. West, who was well on the road
to recovery, insisted on having his say; and, as he discoursed,
Laurence had leisure to take in the magnificence of his surroundings.
The lofty rooms, silken hangings, velvet pile carpets, priceless old
china, and wealth of exotic flowers. Everything seemed to cry out in
chorus, “Money! money! money! Money everywhere.” Madeline, in a
velvet gown, sitting in the midst of it, mistress of all she surveyed,
with a young baronet on one side and a duke’s heir on the other
absolutely hanging on her words. Her beauty, in its setting of brilliant
dress, soft light, and a thousand feminine surroundings, failed to
impress him. It was for this—looking about, and taking in footmen,
pictures, gildings, silver tea equipage, the heavy scented flowers,
soft shaded lamps, the sparkle of diamonds, the titled, appreciative
friends in one searching glance—that she had deserted—yes, that
was the proper word—deserted him and Harry. Even as he watched
her, she was nursing a Chinese lap dog (a hideous beast in his
opinion), and calling the attention of her companions to her darling
Chow-chow’s charms. “Look at his lovely curled tail!” he heard her
exclaim, “and his beautiful little black tongue!” And, meanwhile, the
farmer’s wife was nursing her child, who did not recognize his
mother when he saw her.
 CHAPTER XXX.
MARRIED OR SINGLE?

Mr. West and his new acquaintance had apparently an

inexhaustible capital of conversation, and still kept up the ball, as
other people departed one after the other. Madeline knew that
Laurence was resolved to sit them all out, for, as he laid his cup and
saucer beside her, he said, in a whisper only audible to her, “I’m
going to wait, I must have a word with you alone.”
After a time, when he was positively the last visitor, and the clock
was pointing to half past six, he too rose and took leave of Mr. West
—who expressed a cordial hope that they would see him whenever
they came back to town—and of Madeline, who instead of ringing
the bell, crossed the room with the visitor, airily remarking to her
father, “I’m just going to show Mr. Wynne that last little picture you
bought at Christy’s—he is so fond of paintings. I’ll be back
immediately”—effecting her escape at the same moment by opening
another door, through which she waved her husband, saying
hurriedly, “In here, in here, the picture is there. Come along and
stand before it; and now what is it?”
The room was dimly lit, and there was not much light upon the
painting, but that was of no consequence to Laurence Wynne. He,
however, took his stand before it, glanced at it, and then, turning to
his companion, said gravely, “All right. I’ve come to answer your
letter in person.”
“Laurence! I never knew of such madness! Talk of my going to
your chambers—it was nothing; but for you to venture here——” and
her eyes and gesture became tragic. “Positively, when I saw you
walk in, I felt on the point of fainting.”
“I am glad, however, that you did not get beyond that point. I was
surprised to see your father so well; after your account of him——”
 “Oh, that was written more than a fortnight ago; he is much better
—but weather bound—on account of the snow in the south.
“Well, yes; and your letter was overlooked, and not forwarded. I’ve
been away on circuit.”
“I believe you don’t care whether I never write to you or not; nor to
hear what I’m doing?”
“Oh, but, you know, I am always well posted in the society papers.”
“Society papers!”
“Yes; I see them at my club. Besides, I can actually rise to a
couple of sixpences a week—and I read how the lovely Miss West
was at a ball, looking very smart in straw colour; or had been
observed at church parade wearing her new sables; or shopping in
Bond Street, looking very bright and happy; or—at—the theatre
glorified in diamonds and gold embroideries. However, I have at last
made your father’s acquaintance; he does not seem to be such a
terrible ogre! You may have noticed how pleasant he was to me; we
got on like a house on fire. I do not think that your disclosure will
have the awful consequence you anticipate, and I am perfectly
confident that it will be attended with no ill effects as regards his
health. I am sure you have taken a wrong estimate of his character.
He may fly into a passion just at first—I fancy you may expect that—
but he will calm down, and we shall all be very good friends; and I
am certain he will be delighted with Harry.”
“I am not at all so sanguine as to that,” returned his wife dubiously;
“and you have not yet told me, Laurence—and we have no time to
lose—what has brought you here?”
“I came, as I have said before, to answer your letter in person. I
am glad I have done so, I have seen things with my own eyes, and I
can realize your position more clearly than hitherto. I see you
surrounded with luxury. A duchess could have no more. I see your
father, by no means the frail invalid that I was led to expect; I see
your friends—your—pausing expressively—admirers! I’ve had, in
short, a glimpse into your life, and realized the powerful cords—you
call them claims—that bind you here, and have drawn you away
from me.” He paused again for a moment, making a quick gesture
with his hand to show that Madeline must hear him out. “And now I
have come to tell you my last word. You will—or, if you wish, I will—
tell your father the truth now—within the hour. It will then depend
upon circumstances, whether you leave England or not. If your father
wishes to have you and Harry with him, I shall say nothing against
it.”
Madeline listened to this long and authoritative speech with some
dismay. This plan would not suit her at all. What would all her gay
society friends say—and most of them were coming to the Riviera—
if, instead of the brilliant Miss West, they found Mrs. Wynne—a
prodigal daughter who had married without leave, and who was
hampered with a teething baby? And Laurence was really becoming
quite too overbearing! She would not give in—if she succumbed
now, it was for always. What a fuss he was making, simply because
she was going abroad for three months with her father.
“Surely you can wait until we come back. You see, papa is not in a
state now for any sudden excitement. I will tell him if you wish in a
month, when he has completely recovered——”
“I will wait no longer,” interrupted her husband. “I have already
waited on your good pleasure for close upon a year; put off time after
time, with excuse after excuse, until such a period as you could
manage to screw your courage to the sticking-point. I now
apprehend that that period will be of the same epoch as the Greek
Kalends! Frankly, Madeline, I am not going to stand any more
nonsense. I am your husband; I can support you—certainly only in a
very modest fashion compared to this,” looking round. “You will have
no carriage, no maid, no fine clothes—at least not yet, they may
come by-and-by. Your father is quite fit to travel alone; he ate a
remarkably good tea, and told me that he had played two games of
billiards this afternoon; were he really feeble, it would be a different
affair. It is shameful—yes, that is the only word that will fit the subject
—that I should have to remind you of your child! He should be your
first care. Now, he is delicate, if you like;—he wants his mother, poor
little chap! You will stay at home and look after him. It may not be
your pleasure, but it is unquestionably your duty. You can go to Mrs.
Holt’s and remain there and be welcome as long as you like. You
were very happy there once, Maddie,” he added rather wistfully. No
answer; she merely raised her eyes, and surveyed him fixedly. “I will
look about for a small furnished flat; a little villa at Norwood, or
wherever you like. Lodgings, after this, would be too terrible a
change—I must admit.”
“So would the villa, or even the small flat,” she said to herself. In
one glance she beheld her future: two servants, perhaps; two sitting-
rooms, perhaps; a strip of back garden with stockings on a line;
Laurence absent from morning till night; nothing to do all day long,
but attend to her frugal housekeeping; no smart frocks; no smart
friends; no excitement, amusements, or society.
She glanced at Laurence. Yes, his linen was frayed, there was a
hole in one of his gloves, and in her heart there flared up a
passionate hatred of genteel poverty; it was not life, it was a mere
dragged-out existence, from Sunday to Sunday—from a sirloin of
beef to a fore-quarter of mutton. Ugh! And, on the other hand, the
trip on the Princesse de Lynxky’s yacht, the already made up party
for the carnival, the dresses that she had ordered for both; the
costumes that were to dazzle Nice; the sketch for her carriage at the
battle of flowers. At last she said—
“The child is perfectly well, Laurence. I saw him a week ago, and
he was then the picture of health. He is too young to trouble any one
yet, and Mrs. Holt is an excellent person. Pray how many children
are sent out to nurse, and their parents never see them for two or
three years? It is always done in France, where they manage things
so much better than we do. When Harry is older, it will be quite
different; at present it is all the same to a baby where he is, as long
as he is well cared for. You have suddenly become most arbitrary
and tyrannical; and as to my leaving you for a few months, what is it
after all? Look how wives leave their husbands in India, and come
home for years!” resolved that all the hard hitting should not be on
his side. “You are not like what you used to be, and you are very
cruel to call my conduct shameful—and very rude, too. You are not
going the right way to work, if you want to recall me home—to your
home. I may be led, but I won’t be driven. I shall take my own way
about papa, and tell him at my own time; and, what is more, I shall
certainly accompany him to the Riviera, and when I return I hope,”
speaking breathlessly, and in little short gasps, “I hope that I shall
find you in a more agreeable frame of mind.”
There was an appreciable pause, and then he said, in a tone of
angry astonishment, “Are you in earnest, Madeline?”
“In earnest? Of course I am!”
She looked at him; he had grown visibly paler, and there was a
strange expression in his eyes that she did not remember to have
ever seen before. Then, speaking in a low repressed voice—
“In that case I must ask you now to make your choice, once for all,
between your two characters. You must for the future always be
known as Miss West, or Mrs. Wynne. We will not have this double-
dealing any longer. Now, which will you be, married or single?”
keeping his eyes steadily fixed on her with a look of quiet
determination. “If you wish, we can bury the past.”
No reply. Madeline’s mind was a battle-field of doubt, fear,
amazement, anger, and self-will.
“Speak, Madeline!” he reiterated impatiently. “Married or single?”
“If it were not for the child,” she burst out passionately; “if my life is
to be made a burthen to me like this; if you are always to be
reproaching and scolding me——”
“I see,” he interrupted quickly, “you would rather be Miss West.
The child, I know, is a flimsy excuse, and of no importance; but
please to give me a direct answer. I must have it from your own lips.”
At this critical juncture the door was opened, and Mr. West,
somewhat irascible from having been left so long alone (Mrs. Leach
was dressing for dinner) came in, saying, “Well—well—well—
Madeline, what is the meaning of this? the room is half in darkness.
What the deuce has kept you—has that fellow——? Oh, I beg your
pardon, Mr. Wynne, I did not know you were still here. Can’t have
seen much of the pictures, unless you and Madeline have eyes like
cats.” (No, they had only been fighting like cats.)
 “Answer me, Madeline,” whispered Laurence in a hurried
undertone, holding her hand like a vice. This action was not seen by
Mr. West, who had his back to them, and was occupied with the
poker. “Married or single? Now is the time—I shall tell him.”
“Single!” replied Madeline, hastily wrenching her hand away,
spurred by immediate fears, and regardless of all but the present
moment.
“So be it,” was the low rejoinder.
And Mr. West, as he vigorously poked the fire, and furiously
pressed the bell, had no more idea than poker or button of the
important tie that had just been severed.
Mr. Wynne, looking rather white and stern, came over, and again
took his leave and, without any farewell to Madeline, who was still
standing in the background in the dusk, he opened the door and
departed.
“What have you been doing in here all this time?” asked Mr. West
querulously. “What the deuce have you been about? Looked to me
as if you and that fellow had been having a row. Never saw him
before. Nice gentlemanly chap. None of your ‘Yaw-haw’ sort of
people, with no more brains than a pin, and as much conceit as a
flock of peacocks. No, this man has sense. I——By the way, Maddie,
you look rather put out, too, eh? He has not been proposing for you,
has he? Come now, tell your old daddy,” facetiously. “Make a clean
breast of it.”
“No, papa,” she answered, in a rather shaky tone, “he has not; that
is just the last thing he would do. You won’t see him again, that’s one
comfort!” she added, with a final blaze of temper.
“Comfort, comfort? Not a bit of it. I’d like to see more of him; and
when we come back, remind me to ask him to dinner—he belongs to
the Foolscap Club—don’t forget. What’s his name—Wills—Witts?”
“Wynne.”
“Yes, yes, to be sure! A barrister. Humph! one of the Wynnes of
Rivals Wynne—good old family. Looks a clever chap, too. Bound to
win, eh? Not bad, eh?” chuckling. “But what were you talking about.
You’ve not told me that yet?”
“We were quarrelling, papa, that’s all. Our first and last quarrel,”
attempting to laugh it off, with a laugh that was almost hysterical.
“There’s the first gong!”
“So it is; and I’m quite peckish. Look sharp and dress!” setting an
example on the spot by hurrying out of the room, stick in hand, which
stick went tapping all the way down the corridor, till the sound was
lost in the distance.
Still, Madeline did not stir. She took a step and looked at the
picture. Strange omen! It represented a farewell—a man and a girl.
The man was a soldier, one of Bonaparte’s heroes, and his face was
turned away—the girl was weeping. Then she walked over to the
fire, and stood looking into it with her hands tightly clasped, her heart
beating rather quickly—the after-effects of her late exciting interview.
Her mind was tossed about among conflicting emotions—indignation
with Laurence, relief, regret, all stirring like a swarm of bees
suddenly disturbed. “What had possessed her to marry Laurence
Wynne?” she asked herself, now looking back on their marriage from
the lofty eminence of a spoiled, adulated, and wealthy beauty. A
certain bitter grudge against him and their days of poverty, and the
hateful existence into which he would drag her back, animated her
feelings as she stood before the fire alone.
Such an overbearing, obstinate sort of partner would never suit
her now. He deserved to be taken at his word—though of course he
never meant it. The idea of any sane man relinquishing such a wife
never dawned upon her. Yes—her heart was hot within her—he
might go. As to the child, that was another matter; he was still, of
course, her own pretty darling.
They had never, she and Laurence, had a rift upon the tuneful lute;
and now a little plain speaking and a few angry words had parted
them for life, as he had said. So be it.
“So be it,” she echoed aloud, and pulling a chain from the inside of
her dress, she unfastened it, slipped off her wedding ring, and