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A Discrete-Time Approach to Arbitrage-Free Pricing of Credit Derivatives

by Sanjiv Ranjan Das of Harvard University, and
Rangarajan K. Sundaram of New York University

November 1998

Abstract: This paper develops a framework for modelling risky debt and valuing credit derivatives that is flexible and simple to implement, and that is, to the maximum extent possible, based on observables. Our approach is based on expanding the Heath-Jarrow-Morton termucture model to allow for defaultable debt. We do not follow the procedure of implying out the behavior of spreads from assumptions concerning the default process, instead working directly with the evolution of spreads. We show that risk-neutral drifts in the resulting model possess a recursive representation that particularly facilitates implementation and makes it possible to handle path-dependence and early exercise features without difficulty. The framework permits embedding a variety of specifications for default; we present an empirical example of a default structure which provides promising calibration results.

Published in: Management Science, Vol. 46, No. 1, (January 2000), pp. 46-62.

Previously titled: A Direct Approach to Arbitrage-Free Pricing of Credit Derivatives

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