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Continuous Monitoring: Look before You Leap

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  • Lindset, Snorre

    ()
    (Trondheim Business School)

  • Persson, Svein-Arne

    ()
    (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

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    Abstract

    We present a model for pricing credit risk protection for a limited liability non-life insurance company. The protection is typically provided by a guaranty fund. In the case of continuous monitoring, i.e., where the market values of the company's assets and liabilities are continuously observable, and where the market values of assets and liabilities follow continuous processes, the regulators can liquidate the insurance company at the instant the market value of its assets equals the market value of its liabilities, implying that the credit protection is worthless. When jumps are included in the claims process, the protection provided by the guaranty fund has a strictly positive market value. We argue that the ability to continuously monitor the equity value of a company can be a new explanation for why jump processes may be important in models of credit risk.

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    Bibliographic Info

    Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2008/8.

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    Length: 21 pages
    Date of creation: 12 Mar 2008
    Date of revision:
    Handle: RePEc:hhs:nhhfms:2008_008

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    Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
    Phone: +47 55 95 92 93
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    Web page: http://www.nhh.no/en/research-faculty/department-of-business-and-management-science.aspx
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    Keywords: Credit risk for non-life insurers; guarantee fund; continuous monitoring; barrier options;

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    1. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
    2. Mark Broadie & Paul Glasserman & Steven Kou, 1997. "A Continuity Correction for Discrete Barrier Options," Mathematical Finance, Wiley Blackwell, vol. 7(4), pages 325-349.
    3. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
    4. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
    5. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    6. Lindset, Snorre & Persson, Svein-Arne, 2006. "A note on a barrier exchange option: The world's simplest option formula?," Finance Research Letters, Elsevier, vol. 3(3), pages 207-211, September.
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