An integrated pricing model for defaultable loans and bonds |
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| Institution: | 1. Centre for Financial Econometrics, Deakin Business School, Deakin University, Australia;2. School of Business Monash University, Malaysia;3. School of Economics, Finance & Marketing RMIT University, Melbourne Australia;1. Department of Internal Medicine, Icahn School of Medicine at Mount Sinai St. Luke''s and Mount Sinai West, New York, NY, USA;2. Division of Cardiovascular Disease, Department of Medicine, Mayo Clinic, Rochester, MN, USA;3. Department of Computer Science, Kent State University, OH, USA;4. Robert D. and Patricia E. Kern Center for the Science of Health Care Delivery, Mayo Clinic, Rochester, MN, USA;5. Division of Health Care Policy and Research, Department of Health Sciences Research, Mayo Clinic, Rochester, MN, USA |
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| Abstract: | In recent years, credit risk has played a key role in risk management issues. Practitioners, academics and regulators have been fully involved in the process of developing, studying and analysing credit risk models in order to find the elements which characterize a sound risk management system. In this paper we present an integrated model, based on a reduced pricing approach, for market and credit risk. Its main features are those of being mark to market and that the spread term structure by rating class is contingent on the seniority of debt within an arbitrage-free framework. We introduce issues such as, the integration of market and credit risk, the use of stochastic recovery rates and recovery by seniority. Moreover, we will characterize default risk by estimating migration risk through a “mortality rate”, actuarial-based, approach. The resultant probabilities will be the base for determining multi-period risk-neutral transition probability that allow pricing of risky debt in the trading and banking book. |
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