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Credit Derivatives and Risk Aversion

by Tim Leung of Johns Hopkins University,
Ronnie Sircar of Princeton University, and
Thaleia Zariphopoulou of Oxford University & the University of Texas at Austin

December 2007

Abstract: We discuss the valuation of credit derivatives in extreme regimes such as when the time-to-maturity is short, or when payoff is contingent upon a large number of defaults, as with senior tranches of collateralized debt obligations. In these cases, risk aversion may play an important role, especially when there is little liquidity, and utility-indifference valuation may apply. Specifically, we analyze how short-term yield spreads from defaultable bonds in a structural model may be raised due to investor risk aversion.

JEL Classification: M41, J33, G13.

Keywords: credit risk, utility maximization, defaultable bonds, indifference price.

Published in: Advances in Econometrics, Vol. 22, (2008), pp. 275-291.

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