An Integrated Pricing Model for Defaultable Loans and Bonds

by Mario Onorato of City University, London, and
Edward I. Altman of New York University

March 2005

Abstract: In recent years, credit risk has played a key role in risk management issues. Practitioners, academics and regulators have been fully involved in the process of developing, studying and analysing credit risk models in order to find the elements which characterize a sound risk management system. In this paper we present an integrated model, based on a reduced pricing approach, for market and credit risk. Its main features are those of being mark to market and that the spread term structure by rating class is contingent on the seniority of debt within an arbitrage-free framework. We introduce issues such as, the integration of market and credit risk, the use of stochastic recovery rates and recovery by seniority. Moreover, we will characterise default risk by estimating migration risk through a "mortality rate", actuarial based, approach. The resultant probabilities will be the base for determining multi-period risk-neutral transition probability that allow pricing of risky debt in the trading and banking book.

JEL Classification: C15, C69, G12, H63.

Keywords: statistical simulation methods, financial risk management, credit risk measurement model, asset pricing, debt & debt management.

Published in: European Journal of Operational Research, Vol. 163, No. 1, (May 2005), pp. 65-82.

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