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Ratings-Based Pricing and Stochastic Spreads

by Mariam Harfush-Pardo of Risk Control Limited
Robert Lamb of Imperial College, and
William Perraudin of Imperial College

September 2007

Abstract: This paper generalizes a class of ratings-based credit derivative models proposed by Jarrow, Lando, and Turnbull (1997) and Kijima and Komoribayashi (1998) to allow for stochastic spreads and then applies this model to analyze empirically the pricing of large cross sections of corporate bonds and Asset Backed Securities. We show that measuring risk in credit portfolios is highly sensitive to the inclusion of randomness in spreads.

Keywords: Stochastic spreads, Portfolio risk, empirical spreads model.

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