IDEAS home Printed from https://ideas.repec.org/p/pra/mprapa/7079.html
   My bibliography  Save this paper

Risky Swaps

Author

Listed:
  • Gikhman, Ilya

Abstract

In [10] we presented a reduced form of risky bond pricing. At the default date a bond seller fail to continue fulfill his obligation and the price of the bond sharply drops down. If the face value of the defaulted bond for no-default scenarios is $1 then the bond price just after default is called its recovery rate (RR). Rating agencies and theoretical models are trying to predict RR for companies or sovereign countries. The main theoretical problem with a risky bond or with general debt problems is presenting the price given the RR. The problem of a credit default swap (CDS) pricing is somewhat an adjacent problem. Recall that the corporate bond price is inversely depends on interest rate. The credit risk on a debt investment is related to the loss if default occurs. There exist a possibility for a risky bond buyer to reduce his credit risk. This can be achieved by buying a protection from a protection seller. The bondholder would pay a fixed premium up to maturity or default, which one comes first. In exchange if default comes before maturity the protection buyer will receive the difference between the initially set face value of the bond and RR. This difference is called ‘loss given default’. This contract represents CDS. The counterparty that pays a fixed premium is called CDS buyer or protection buyer and the opposite party is the CDS seller. Note that in contrast to corporate bond CDS contract does not assume that buyer of the CDS is a holder of the underlying bond. Note that underlying to the swap can be any asset. It is called the reference asset or reference entity. Thus CDS is a credit instrument that separates credit risk from corresponding underlying entity. Thus the formal type of the CDS can be described as follows. The buyer of the credit swap pays fixed rate or coupon until maturity or default if it occurs sooner than maturity. In case of default protection buyer delivers cash or default asset in exchange of the face value of the defaulted debt. These are known as cash or physical settlements correspondingly.

Suggested Citation

  • Gikhman, Ilya, 2008. "Risky Swaps," MPRA Paper 7079, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:7079
    as

    Download full text from publisher

    File URL: https://mpra.ub.uni-muenchen.de/7079/1/MPRA_paper_7079.pdf
    File Function: original version
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
    2. ilya, gikhman, 2005. "Options valuation," MPRA Paper 1452, University Library of Munich, Germany.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Ilya, Gikhman, 2007. "Corporate debt pricing I," MPRA Paper 1450, University Library of Munich, Germany.
    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Ilya, Gikhman, 2008. "Multiple risky securities valuation I," MPRA Paper 34511, University Library of Munich, Germany, revised 2011.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Jeremy Leake, 2003. "Credit spreads on sterling corporate bonds and the term structure of UK interest rates," Bank of England working papers 202, Bank of England.
    2. Chava, Sudheer & Jarrow, Robert, 2008. "Modeling loan commitments," Finance Research Letters, Elsevier, vol. 5(1), pages 11-20, March.
    3. 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.
    4. Alejandro Revéiz Hérault, "undated". "Factores determinantes de los márgenes entre bonos del gobierno y bonos corporativos en los Estados Unidos," Lecturas en Finanzas 002710, Banco de la Republica de Colombia.
    5. Nan Chen & S. G. Kou, 2009. "Credit Spreads, Optimal Capital Structure, And Implied Volatility With Endogenous Default And Jump Risk," Mathematical Finance, Wiley Blackwell, vol. 19(3), pages 343-378, July.
    6. John Y. Campbell & Glen B. Taksler, 2003. "Equity Volatility and Corporate Bond Yields," Journal of Finance, American Finance Association, vol. 58(6), pages 2321-2350, December.
    7. Michael C. Munnix & Rudi Schafer & Thomas Guhr, 2011. "A Random Matrix Approach to Credit Risk," Papers 1102.3900, arXiv.org, revised Jun 2011.
    8. Wisniewski, Tomasz Piotr & Lambe, Brendan John, 2015. "Does economic policy uncertainty drive CDS spreads?," International Review of Financial Analysis, Elsevier, vol. 42(C), pages 447-458.
    9. Chen, An-Sing & Chu, Hsiang-Hui & Hung, Pi-Hsia & Cheng, Miao-Sih, 2020. "Financial risk and acquirers' stockholder wealth in mergers and acquisitions," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).
    10. Viviana Fanelli & Silvana Musti, 2007. "Modelling Credit Spreads evolution using the Cox Process within the HJM framework," Quaderni DSEMS 27-2007, Dipartimento di Scienze Economiche, Matematiche e Statistiche, Universita' di Foggia.
    11. Giesecke, Kay & Longstaff, Francis A. & Schaefer, Stephen & Strebulaev, Ilya, 2011. "Corporate bond default risk: A 150-year perspective," Journal of Financial Economics, Elsevier, vol. 102(2), pages 233-250.
    12. Kraft, Holger & Steffensen, Mogens, 2008. "How to invest optimally in corporate bonds: A reduced-form approach," Journal of Economic Dynamics and Control, Elsevier, vol. 32(2), pages 348-385, February.
    13. Hamerle, Alfred & Knapp, Michael & Wildenauer, Nicole, 2005. "Auswirkungen unterschiedlicher Assetkorrelationen in Mehr-Sektoren-Kreditportfoliomodellen," University of Regensburg Working Papers in Business, Economics and Management Information Systems 409, University of Regensburg, Department of Economics.
    14. Jobst, Norbert J. & Zenios, Stavros A., 2005. "On the simulation of portfolios of interest rate and credit risk sensitive securities," European Journal of Operational Research, Elsevier, vol. 161(2), pages 298-324, March.
    15. Duffie, Darrell, 2005. "Credit risk modeling with affine processes," Journal of Banking & Finance, Elsevier, vol. 29(11), pages 2751-2802, November.
    16. Murray Carlson & Ali Lazrak, 2006. "Leverage Choice and Credit Spread Dynamics when Managers Risk Shift," 2006 Meeting Papers 193, Society for Economic Dynamics.
    17. Maciej Firla-Cuchra, 2005. "Explaining Launch Spreads on Structured Bonds," Economics Series Working Papers 230, University of Oxford, Department of Economics.
    18. Chiarella, Carl & Fanelli, Viviana & Musti, Silvana, 2011. "Modelling the evolution of credit spreads using the Cox process within the HJM framework: A CDS option pricing model," European Journal of Operational Research, Elsevier, vol. 208(2), pages 95-108, January.
    19. Samuel Chege Maina, 2011. "Credit Risk Modelling in Markovian HJM Term Structure Class of Models with Stochastic Volatility," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1-2011.
    20. Sanjiv Das & Xin Huang & Soji Adeshina & Patrick Yang & Leonardo Bachega, 2023. "Credit Risk Modeling with Graph Machine Learning," INFORMS Joural on Data Science, INFORMS, vol. 2(2), pages 197-217, October.

    More about this item

    Keywords

    Black Scholes equation; option price; credit default swap; constant maturity default swap; equity default swap; asset swap; total return swap; credit-linked note; floating rate risky bond; counterparty risk; risky present value;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:pra:mprapa:7079. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Joachim Winter (email available below). General contact details of provider: https://edirc.repec.org/data/vfmunde.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.