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Pricing and Hedging of Credit Derivatives via the Innovations Approach to Nonlinear Filtering

by Rüdiger Frey of the University of Leipzig, and
Thorsten Schmidt of Chemnitz University of Technology

June 2010

Abstract: In this paper we propose a new, information-based approach for modelling the dynamic evolution of a portfolio of credit risky securities. In our setup market prices of traded credit derivatives are given by the solution of a nonlinear filtering problem. The innovations approach to nonlinear filtering is used to solve this problem and to derive the dynamics of market prices. Moreover, the practical application of the model is discussed: we analyse calibration, the pricing of exotic credit derivatives and the computation of risk-minimizing hedging strategies. The paper closes with a few numerical case studies.

Keywords: Credit derivatives, incomplete information, nonlinear filtering, hedging.

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