
 Credit Spread Bounds and their Implications for Credit Risk Modeling by RenRaw Chen of Rutgers University, and June 20, 2002 Abstract: Analogous to the yield curve which is essential in pricing interest rate contingent claims, the default probability curve is indispensable for pricing credit derivatives. However, when such a curve is generated by calibrating credit models to observed credit spreads, negative default probabilities often occur, which indicates a violation of no arbitrage. In this paper we present a formal treatment of this negative probability problem known in the credit researcher community. Specifically, for a large class of credit models we derive a set of analytical bounds within which a model will be consistent with an observed term structure of credit spreads (in the sense that the modelimplied default probabilities are well defined). We also obtain some general results regarding the implications of the shape of the observed credit spread curve on the consistency of a credit risk model. In particular, we identify a class of models that are consistent only when the observed credit spread curves are flat at the long end. Books Referenced in this paper: (what is this?) 