Security Pricing with Information-Sensitive Discounting

Andrea Macrina and Priyanka A. Parbhoo
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Andrea Macrina: Department of Mathematics, King's College London, London WC2R 2LS, United Kingdom and Institute of Economic Research, Kyoto University, Kyoto 606-8501, Japan
Priyanka A. Parbhoo: School of Computational and Applied Mathematics, University of the Witwatersrand, Johannesburg, Private Bag-3, Wits 2050, South Africa

Chapter 6 in Recent Advances in Financial Engineering 2009, 2010, pp 157-180 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractIn this paper, incomplete-information models are developed for the pricing of securities in a stochastic interest rate setting. In particular, we consider credit-risky assets that may include random recovery upon default. The market filtration is generated by a collection of information processes associated with economic factors, on which interest rates depend, and information processes associated with market factors used to model the cash flows of the securities. We use information-sensitive pricing kernels to give rise to stochastic interest rates. Semi-analytical expressions for the price of credit-risky bonds are derived, and a number of recovery models are constructed which take into account the perceived state of the economy at the time of default. The price of a European-style call bond option is deduced, and it is shown how examples of hybrid securities, like inflation-linked credit-risky bonds, can be valued. Finally, a cumulative information process is employed to develop pricing kernels that respond to the amount of aggregate debt of an economy.

Keywords: Financial Engineering; Mathematical Finance; Credit Risk; Real Options; Optimal Investment; Heterogeneous Beliefs (search for similar items in EconPapers)
Date: 2010
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