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On modelling credit risk using Arbitrage Free Models

Author

Listed:
  • Frank Skinner

    () (ICMA Centre, University of Reading)

  • Antonio Diaz

    (Associate Professor - Departamento de Economia y Empresa, Universidad de Castilla - La Mancha, Span)

Abstract

By examining the distribution of state prices obtained from binomial versions of Jarrow and Turnbull (1995), Lando (1998) and Duffie and Singleton (1999), we are able to suggest which credit risk parameters are of critical interest. We find that it appears worthwhile to parameterize credit risk since even the simplest parameterized model obtains large changes in the distribution of state prices when compared to a non-parameterized model. Similarly we find large differences in the distribution of state prices as we add correlation and moderate changes as we add time varying recovery rates. Finally, the choice between the RM or RF recovery assumption appears innocuous, but the choice between RT and these two recovery assumptions is not.

Suggested Citation

  • Frank Skinner & Antonio Diaz, 2001. "On modelling credit risk using Arbitrage Free Models," ICMA Centre Discussion Papers in Finance icma-dp2000-08, Henley Business School, Reading University, revised Mar 2000.
  • Handle: RePEc:rdg:icmadp:icma-dp2000-08
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    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2000-08.pdf
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    References listed on IDEAS

    as
    1. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    2. Vasicek, Oldrich A & Fong, H Gifford, 1982. " Term Structure Modeling Using Exponential Splines," Journal of Finance, American Finance Association, vol. 37(2), pages 339-348, May.
    3. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453 World Scientific Publishing Co. Pte. Ltd..
    4. Sarig, Oded & Warga, Arthur, 1989. "Bond Price Data and Bond Market Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 367-378, September.
    5. 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..
    6. McCulloch, J Huston, 1975. "The Tax-Adjusted Yield Curve," Journal of Finance, American Finance Association, vol. 30(3), pages 811-830, June.
    7. Edwin J. Elton & T. Clifton Green, 1998. "Tax and Liquidity Effects in Pricing Government Bonds," Journal of Finance, American Finance Association, vol. 53(5), pages 1533-1562, October.
    8. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    9. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-489, October.
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    More about this item

    Keywords

    Credit risk; credit derivatives; binomial lattice; arbitrage free pricing;

    JEL classification:

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

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