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A Guide to Modeling Credit Term Structures

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  • Arthur M. Berd
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    Abstract

    We give a comprehensive review of credit term structure modeling methodologies. The conventional approach to modeling credit term structure is summarized and shown to be equivalent to a particular type of the reduced form credit risk model, the fractional recovery of market value approach. We argue that the corporate practice and market observations do not support this approach. The more appropriate assumption is the fractional recovery of par, which explicitly violates the strippable cash flow valuation assumption that is necessary for the conventional credit term structure definitions to hold. We formulate the survival-based valuation methodology and give alternative specifications for various credit term structures that are consistent with market observations, and show how they can be empirically estimated from the observable prices. We rederive the credit triangle relationship by considering the replication of recovery swaps. We complete the exposition by presenting a consistent measure of CDS-Bond basis and demonstrate its relation to a static hedging strategy, which remains valid for non-par bonds and non-flat term structures of interest rates and credit risk.

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    File URL: http://arxiv.org/pdf/0912.4623
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    Paper provided by arXiv.org in its series Papers with number 0912.4623.

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    Date of creation: Dec 2009
    Date of revision: Dec 2009
    Handle: RePEc:arx:papers:0912.4623

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    1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Vasicek, Oldrich A & Fong, H Gifford, 1982. " Term Structure Modeling Using Exponential Splines," Journal of Finance, American Finance Association, vol. 37(2), pages 339-48, May.
    3. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
    4. Robert A. Jarrow, 2009. "Credit Risk Models," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 37-68, November.
    5. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
    6. Das, Sanjiv R. & Hanouna, Paul, 2009. "Implied recovery," Journal of Economic Dynamics and Control, Elsevier, vol. 33(11), pages 1837-1857, November.
    7. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
    8. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    9. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
    10. Jarrow, Robert A. & Turnbull, Stuart M., 2000. "The intersection of market and credit risk," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 271-299, January.
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