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Arbitrage-free credit pricing using default probabilities and risk sensitivities

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  • Blöchlinger, Andreas
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    Abstract

    The relation between physical probabilities (rating) and risk-neutral probabilities (pricing) is derived in a large market with a quasi-factor structure. Factor sensitivities and default probabilities are obtainable for all kinds of credits on historical rating data. Since factor prices can be backed out from market data, the model allows the pricing of non-marketable credits and structured products thereof. The model explains various empirical observations: credit spreads of equally rated borrowers differ, spreads are wider than implied by expected losses, and expected returns on CDOs must be greater than their rating matched, single-obligor securities due to the inherent systematic risk.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 35 (2011)
    Issue (Month): 2 (February)
    Pages: 268-281

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    Handle: RePEc:eee:jbfina:v:35:y:2011:i:2:p:268-281

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Arbitrage pricing theory Collateralized debt obligation Esscher's measure change Risk-neutral default probability Generalized linear mixed model;

    References

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    Cited by:
    1. Câmara, António & Popova, Ivilina & Simkins, Betty, 2012. "A comparative study of the probability of default for global financial firms," Journal of Banking & Finance, Elsevier, vol. 36(3), pages 717-732.
    2. Tsaig, Yaakov & Levy, Amnon & Wang, Yashan, 2011. "Analyzing the impact of credit migration in a portfolio setting," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3145-3157.

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