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A CB (corporate bond) pricing probabilities and recovery rates model for deriving default probabilities and recovery rates

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  • Takeaki Kariya

Abstract

In this paper we formulate a corporate bond (CB) pricing model for deriving the term structure of default probabilities (TSDP) and the recovery rate (RR) for each pair of industry factor and credit rating grade, and these derived TSDP and RR are regarded as what investors imply in forming CB prices in the market at each time. A unique feature of this formulation is that the model allows each firm to run several business lines corresponding to some industry categories, which is typical in reality. In fact, treating all the cross-sectional CB prices simultaneously under a credit correlation structure at each time makes it possible to sort out the overlapping business lines of the firms which issued CBs and to extract the TSDPs for each pair of individual industry factor and rating grade together with the RRs. The result is applied to a valuation of CDS (credit default swap) and a loan portfolio management in banking business.

Suggested Citation

  • Takeaki Kariya, 2012. "A CB (corporate bond) pricing probabilities and recovery rates model for deriving default probabilities and recovery rates," Papers 1206.4766, arXiv.org, revised Jul 2012.
  • Handle: RePEc:arx:papers:1206.4766
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    1. 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..
    2. Pierre Collin‐Dufresne & Bruno Solnik, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, June.
    3. Darrell Duffie & Rui Kan, 1996. "A Yield‐Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406, October.
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    Cited by:

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    2. Aikman, David & Galesic, Mirta & Gigerenzer, Gerd & Kapadia, Sujit & Katsikopoulos, Konstantinos & Kothiyal, Amit & Murphy, Emma & Neumann, Tobias, 2014. "Financial Stability Paper No 28: Taking uncertainty seriously - simplicity versus complexity in financial regulation," Bank of England Financial Stability Papers 28, Bank of England.

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