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Pricing Credit Derivatives with Rating Transitions

Viral Acharya (), Sanjiv Das () and Rangarajan K Sundaram

No 3329, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We develop a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach is based on expanding the Heath-Jarrow-Morton (1990) term-structure model and its extension, the Das-Sundaram (2000) model to allow for defaultable debt with rating transitions. The framework has two salient features, comprising extensions over the earlier work: (i) it employs a rating transition matrix as the driver for the default process, and (ii) the entire set of rating categories is calibrated jointly, allowing, with minimal assumptions, arbitrage-free restrictions across rating classes, as a bond migrates amongst them. We provide an illustration of the approach by applying it to price credit sensitive notes that have coupon payments that are linked to the rating of the underlying credit.

Keywords: credit derivatives; credit sensitive note; HJM model; rating transitions; risky debt (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-fin and nep-fmk
Date: 2002-04
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