DEFAULT RISK AND DIVERSIFICATION: THEORY AND EMPIRICAL IMPLICATIONS

Robert Jarrow (), David Lando and Fan Yu
Additional contact information
Fan Yu: University of California, Irvine, USA

Chapter 19 in Financial Derivatives Pricing:Selected Works of Robert Jarrow, 2008, pp 455-480 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractRecent advances in the theory of credit risk allow the use of standard term structure machinery for default risk modeling and estimation. The empirical literature in this area often interprets the drift adjustments of the default intensity's diffusion state variables as the only default risk premium. We show that this interpretation implies a restriction on the form of possible default risk premia, which can be justified through exact and approximate notions of "diversifiable default risk." The equivalence between the empirical and martingale default intensities that follows from diversifiable default risk greatly facilitates the pricing and management of credit risk. We emphasize that this is not an equivalence in distribution, and illustrate its importance using credit spread dynamics estimated in Duffee (1999). We also argue that the assumption of diversifiability is implicitly used in certain existing models of mortgage-backed securities.

Keywords: Derivatives; Options; Hedging; HJM; Black–Scholes; Forwards; Futures; Martingale Measure; Calls; Puts; Market Manipulation; Margin Requirements (search for similar items in EconPapers)
Date: 2008
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.worldscientific.com/doi/pdf/10.1142/9789812819222_0019 (application/pdf)
https://www.worldscientific.com/doi/abs/10.1142/9789812819222_0019 (text/html)
Ebook Access is available upon purchase.

Related works:
Journal Article: DEFAULT RISK AND DIVERSIFICATION: THEORY AND EMPIRICAL IMPLICATIONS (2005)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:wschap:9789812819222_0019

Ordering information: This item can be ordered from

Access Statistics for this chapter

More chapters in World Scientific Book Chapters from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().