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Defaultable Security Valuation and Model Risk

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  • Aydin AKGUN,

    (University of Lausanne and FAME)

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    Abstract

    The aim of the paper is to analyse the effects of different model specifications, within a general nested framework, on the valuation of defaultable bonds, and some credit derivatives. Assuming that the primitive variables such as the risk-free short rate, and the credit spread are affine functions of a set state variables following jump-diffusion processes, efficient numerical solutions for the prices of several defaultable securities are provided. The framework is flexible enough to permit some degree of freedom in specifying the interrelation among the primitive variables. It also allows a richer economic interpretation for the default process. The model is calibrated, and a sensitivity analysis is conducted with respect to parameters defining jump terms, and correlation. The effectiveness of dynamic hedging strategies are analysed as well.

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    File URL: http://www.swissfinanceinstitute.ch/rp28.pdf
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    Bibliographic Info

    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp28.

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    Date of creation: Mar 2001
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    Handle: RePEc:fam:rpseri:rp28

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    1. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    2. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    3. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
    4. 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.
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    Cited by:
    1. Roger WALDER, 2002. "Interactions Between Market and Credit Risk: Modeling the Joint Dynamics of Default-Free and Defaultable Bond Term Structures," FAME Research Paper Series rp56, International Center for Financial Asset Management and Engineering.

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