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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.

Suggested Citation

  • Hugues Pirotte, 1999. "Implementing a Structural Valuation Model of Swap Credit-Sensitive Rates," Working Papers CEB 99-001.RS, ULB -- Universite Libre de Bruxelles.
  • Handle: RePEc:sol:wpaper:99-001
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    References listed on IDEAS

    as
    1. Duffee, Gregory R., 1996. "On measuring credit risks of derivative instruments," Journal of Banking & Finance, Elsevier, vol. 20(5), pages 805-833, June.
    2. Didier Cossin & Hugues Pirotte, 1998. "How well do classical credit risk pricing models fit swap transaction data?," European Financial Management, European Financial Management Association, vol. 4(1), pages 65-77.
    3. 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 351-367, May.
    4. Campbell, John Y, 1986. " A Defense of Traditional Hypotheses about the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 41(1), pages 183-193, March.
    5. Hubner, Georges, 2001. "The analytic pricing of asymmetric defaultable swaps," Journal of Banking & Finance, Elsevier, vol. 25(2), pages 295-316, February.
    6. 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..
    7. 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.
    8. Hugues Pirotte, 1999. "A Structural Model of the Term Structure of Credit Spreads with Stochastic Recovery and Contractual Design," Working Papers CEB 99-002.RS, ULB -- Universite Libre de Bruxelles.
    9. 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.
    10. 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 1209-1227, July.
    11. 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.
    12. 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.
    13. 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.
    14. 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, vol. 55(2), pages 391-407, March.
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    16. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-949, July.
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    More about this item

    Keywords

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

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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