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A Discrete-Time Approach to Arbitrage-Free Pricing of Credit Derivatives

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Author Info

  • Sanjiv Ranjan Das

    ()
    (Harvard University & NBER, Graduate School of Business, Boston, Massachusetts 02163)

  • Rangarajan K. Sundaram

    ()
    (New York University, Stern School of Business, New York, New York 10012)

Abstract

This paper develops a framework for modelling risky debt and valuing credit derivatives that is flexible and simple to implement, and that is, to the maximum extent possible, based on observables. Our approach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable debt. Rather than follow the procedure of implying out the behavior of spreads from assumptions concerning the default process, we work directly with the evolution of spreads. The risk-neutral drifts in the resulting model possess a recursive representation that facilitates implementation and makes it possible to handle path-dependence and early exercise features without difficulty. The framework permits embedding a variety of specifications for default; we present an empirical example of a default structure which provides promising calibration results.

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File URL: http://dx.doi.org/10.1287/mnsc.46.1.46.15124
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 46 (2000)
Issue (Month): 1 (January)
Pages: 46-62

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Handle: RePEc:inm:ormnsc:v:46:y:2000:i:1:p:46-62

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Related research

Keywords: Credit Risk; Derivatives; No-Arbitrage;

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Cited by:
  1. Haibin Zhu, 2006. "An Empirical Comparison of Credit Spreads between the Bond Market and the Credit Default Swap Market," Journal of Financial Services Research, Springer, vol. 29(3), pages 211-235, June.
  2. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2004. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default Swap Market," NBER Working Papers 10418, National Bureau of Economic Research, Inc.
  3. Houweling, Patrick & Vorst, Ton, 2005. "Pricing default swaps: Empirical evidence," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1200-1225, December.
  4. Carl Chiarella & Viviana Fanelli & Silvana Musti, 2009. "Modelling the Evolution of Credit Spreads Using the Cox Process Within the HJM Framework A CDS Option Pricing Model," Research Paper Series 255, Quantitative Finance Research Centre, University of Technology, Sydney.
  5. Masakazu Miura & Kenichiro Tamaki & Takayuki Shiohama, 2013. "Asymptotic Expansion for Term Structures of Defaultable Bonds with Non-Gaussian Dependent Innovations," Asia-Pacific Financial Markets, Springer, vol. 20(4), pages 311-344, November.
  6. Michael Adler & Jeong Song, 2010. "The behavior of emerging market sovereigns' credit default swap premiums and bond yield spreads," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 15(1), pages 31-58.
  7. Duffie, Darrell, 2003. "Intertemporal asset pricing theory," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 11, pages 639-742 Elsevier.
  8. Longstaff, Francis A. & Mithal, Sanjay & Neis, Eric, 2004. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default Swap Market, previously titled: "The Credit-Default Swap Market: Is Credit Protection Priced Correctly?&qu," University of California at Los Angeles, Anderson Graduate School of Management qt8gn7h03k, Anderson Graduate School of Management, UCLA.
  9. Augusto Castillo, 2004. "Firm and Corporate Bond Valuation: A Simulation Dynamic Programming Approach," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 41(124), pages 345-360.
  10. Francois, Pascal & Hubner, Georges, 2004. "Credit derivatives with multiple debt issues," Journal of Banking & Finance, Elsevier, vol. 28(5), pages 997-1021, May.
  11. Chuang-Chang Chang & Ruey-Jenn Ho & Chengfew Lee, 2010. "Pricing credit card loans with default risks: a discrete-time approach," Review of Quantitative Finance and Accounting, Springer, vol. 34(4), pages 413-438, May.
  12. Gady Jacoby & Chuan Liao & Jonathan A. Batten, 2007. "A Pure Test for the Elasticity of Yield Spreads," The Institute for International Integration Studies Discussion Paper Series iiisdp195, IIIS.
  13. Acharya, Viral V & Bharath, Sreedhar T & Srinivasan, Anand, 2003. "Understanding the Recovery Rates on Defaulted Securities," CEPR Discussion Papers 4098, C.E.P.R. Discussion Papers.

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