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A Tree Implementation of a Credit Spread Model for Credit Derivatives

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  • Schönbucher, Philipp J.

Abstract

In this paper we present a tree model for defaultable bond prices which can be used for the pricing of credit derivatives. The model is based upon the two-factor Hull-White (1994) model for default-free interest rates, where one of the factors is taken to be the credit spread of the defaultable bond prices. As opposed to the tree model of Jarrow and Turnbull (1992), the dynamics of default-free interest rates and credit spreads in this model can have any desired degree of correlation, and the model can be fitted to any given term structures of default-free and defaultable bond prices, and to the term structures of the respective volatilities. Furthermore the model can accommodate several alternative models of default recovery, including the fractional recovery model of Duffie and Singleton (1994) and recovery in terms of equivalent default-free bonds (see e.g. Lando (1998)). Although based on a Gaussian setup, the approach can easily be extended to non-Gaussian processes that avoid negative interest-rates or credit spreads.

Suggested Citation

  • Schönbucher, Philipp J., 2000. "A Tree Implementation of a Credit Spread Model for Credit Derivatives," Bonn Econ Discussion Papers 17/2001, University of Bonn, Bonn Graduate School of Economics (BGSE).
    • Handle: RePEc:zbw:bonedp:172001
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    References listed on IDEAS

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    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. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
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    Cited by:

    1. Joao B. C. Garcia & Helmut van Ginderen & Reinaldo C. Garcia, 2003. "On the Pricing of Credit Spread Options: A Two Factor HW–BK Algorithm," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 6(05), pages 491-505.
    2. Emmanuel Mamatzakis & Panos Remoundos, 2012. "What are the Driving Factors Behind the Rise of Spreads and CDS of Eurozone Sovereign Bonds? A Panel VAR Analysis," World Scientific Book Chapters, in: Risk Management Institute, Singapore (ed.), Global Credit Review, chapter 5, pages 79-94, World Scientific Publishing Co. Pte. Ltd..
    3. Norbert Jobst & Stavros A. Zenios, 2001. "Extending Credit Risk (Pricing) Models for the Simulation of Portfolios of Interest Rate and Credit Risk Sensitive Securities," Center for Financial Institutions Working Papers 01-25, Wharton School Center for Financial Institutions, University of Pennsylvania.
    4. Leslie Ng, 2013. "Numerical Procedures For A Wrong Way Risk Model With Lognormal Hazard Rates And Gaussian Interest Rates," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 16(08), pages 1-33.

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    More about this item

    Keywords

    credit derivatives; credit risk; implementation; Hull-White model;
    All these keywords.

    JEL classification:

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

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