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Implementing a Structural Valuation Model of Swap Credit-Sensitive Rates

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  • Hugues Pirotte

Abstract

Currency and interest rate swaps are subject to a complex, two-sided default risk. Several theoretical papers have addressed the problem of pricing swap credit risk. I propose a complete implementation procedure of the structural line of research in theoretical credit risk analysis in order to attempt to evaluate an OTC contract such as the swap contract. It is shown how structural models can enable us to extract the whole credit risk information from scarce data if of good quality, which leads to the problem of mixing accounting and available financial data from traded prices. Ther analytical results are therefore benchmarked against actual transaction data. Although the results are not very satisfactory for swap pricing, the procedure provides interesting insights in some parameter estimations linked to the credit worthiness of the firm that show to be consistent indicators, useful for credit risk management purposes.

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Bibliographic Info

Paper provided by ULB -- Universite Libre de Bruxelles in its series Working Papers CEB with number 99-001.RS.

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Length: 34 p.
Date of creation: 1999
Date of revision:
Publication status: Published by:
Handle: RePEc:sol:wpaper:99-001

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Keywords: derivatives; swaps; credit risk; transaction data; model calibration.;

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References

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  1. Saa-Requejo, Jesus & Santa-Clara, Pedro, 1997. "Bond Pricing with Default Risk," University of California at Los Angeles, Anderson Graduate School of Management qt3w71g2ch, Anderson Graduate School of Management, UCLA.
  2. John Y. Campbell, 1986. "A Defense of Traditional Hypotheses About the Term Structure of InterestRates," NBER Working Papers 1508, National Bureau of Economic Research, Inc.
  3. Hugues Pirotte & Didier Cossin, 1998. "How Well Do Classical Credit Risk Pricing Models Fit Swap Transaction Data?," Working Papers CEB, ULB -- Universite Libre de Bruxelles 98-001, ULB -- Universite Libre de Bruxelles.
  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., 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.
  6. Hubner, Georges, 2001. "The analytic pricing of asymmetric defaultable swaps," Journal of Banking & Finance, Elsevier, vol. 25(2), pages 295-316, February.
  7. Duffee, Gregory R., 1996. "On measuring credit risks of derivative instruments," Journal of Banking & Finance, Elsevier, vol. 20(5), pages 805-833, June.
  8. Cossin, Didier & Pirotte, Hugues, 1997. "Swap credit risk: An empirical investigation on transaction data," Journal of Banking & Finance, Elsevier, vol. 21(10), pages 1351-1373, October.
  9. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, Econometric Society, vol. 55(2), pages 391-407, March.
  10. 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.
  11. Hugues Pirotte, 1999. "A Structural Model of the Term Structure of Credit Spreads with Stochastic Recovery and Contractual Design," Working Papers CEB, ULB -- Universite Libre de Bruxelles 99-002.RS, ULB -- Universite Libre de Bruxelles.
  12. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-49, July.
  13. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
  14. Gregory R. Duffee, 1995. "The variation of default risk with Treasury yields," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 29-58.
  15. Ronn, Ehud I & Verma, Avinash K, 1986. " Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-95, September.
  16. Sun, Tong-sheng & Sundaresan, Suresh & Wang, Ching, 1993. "Interest rate swaps: An empirical investigation," Journal of Financial Economics, Elsevier, vol. 34(1), pages 77-99, August.
  17. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
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