Beyond Hazard Rates: A New Framework for Credit-Risk Modelling

Brody, Dorje C; Hughston, L P and Macrina, Andrea. 2007. Beyond Hazard Rates: A New Framework for Credit-Risk Modelling. In: M C Fu; R A Jarrow; J J Yen and R J Elliott, eds. Advances in Mathematical Finance. Birkhäuser, pp. 231-257. ISBN 9780817645441 [Book Section]

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Abstract or Description

A new approach to credit risk modelling is introduced that avoids the use of inaccessible stopping times. Default events are associated directly with the failure of obligors to make contractually agreed payments. Noisy information about impending cash flows is available to market participants. In this framework, the market filtration is modelled explicitly, and is assumed to be generated by one or more independent market information processes. Each such information process carries partial information about the values of the market factors that determine future cash flows. For each market factor, the rate at which true information is provided to market participants concerning the eventual value of the factor is a parameter of the model. Analytical expressions that can be readily used for simulation are presented for the price processes of defaultable bonds with stochastic recovery. Similar expressions can be formulated for other debt instruments, including multi-name products. An explicit formula is derived for the value of an option on a defaultable discount bond. It is shown that the value of such an option is an increasing function of the rate at which true information is provided about the terminal payoff of the bond. One notable feature of the framework is that it satisfies an overall dynamic consistency condition that makes it suitable as a basis for practical modelling situations where frequent recalibration may be necessary.

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Book Section

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Credit risk, credit derivatives, incomplete information, informationbased asset pricing, market filtration, Bayesian inference, Brownian bridge process

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Date Deposited:

10 Feb 2022 16:50

Last Modified:

10 Feb 2022 16:53


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