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Beyond Hazard Rates: A new framework for credit-risk modeling

by Dorje C. Brody of the Imperial College,
Lane P. Hughston of King's College London, and
Andrea Macrina of King's College London

November 2006

Summary: 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.

JEL Classification: G12, G13.

Keywords: Credit risk, credit derivatives, incomplete information, information-based asset pricing, market filtration, Bayesian inference, Brownian bridge process.

This paper is republished as Ch.13 in...

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