The Market Price Of Credit Risk
- Topics:
- Commercial Lending
- Tags:
- Aversion,
- Market Price,
- Recovery,
- Security
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Overview: The article describes the relationship between actual probability of default and defaultable security prices. The starting point is a first passage time model of default based on incomplete information. This model incorporates the unpredictable nature of default and thereby accounts for positive short spreads and the abrupt drops in defaultable security prices that occur at default. To connect prices with actual default probabilities, it analyzes post-default recovery and the credit risk premium. Its recovery model is a generalization of the fractional market value convention introduced by Duffie & Singleton (1999) for intensity-based credit models. It derives generalized reduced-form pricing formulae for defaultable securities subject to fractional recovery. The credit risk premium has two components. One accounts for investors’ aversion towards diffusive price volatility. The other reflects aversion toward the price jumps that occur at default, or more generally toward the default event itself. The article concludes with a forward looking discussion of model calibration, and outline a strategy to extract the credit risk premium from market prices of defaultable securities.
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Format: PDF | Size: 246KB | Date: Nov 2003 | Pages: 34
