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DEFAULT RISK AND DIVERSIFICATION: THEORY AND EMPIRICAL IMPLICATIONS

Robert Jarrow (), David Lando () and Fan Yu
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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)
JEL-codes: B26 O16 E44 (search for similar items in EconPapers)
Date: 2008
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Journal Article: DEFAULT RISK AND DIVERSIFICATION: THEORY AND EMPIRICAL IMPLICATIONS (2005) Downloads
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