Abstract

http://ssrn.com/abstract=1667082
 
 

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An Integrated Model for Hybrid Securities


Sanjiv Ranjan Das


Santa Clara University - Leavey School of Business

Rangarajan K. Sundaram


New York University (NYU) - Department of Finance

September 1, 2007

Management Science, Vol. 53, No. 9, pp. 1439-1451, 2007

Abstract:     
We develop a model for pricing securities whose value may depend simultaneously on equity, interest rate, and default risks. The framework may also be used to extract probabilities of default (PD) functions from market data. Our approach is entirely based on observables such as equity prices and interest rates, rather than on unobservable processes such as firm value. The model stitches together in an arbitrage-free setting a constant elasticity of variance (CEV) equity model (to represent the behavior of equity prices prior to default), a default intensity process, and a Heath-Jarrow-Morton (HJM) model for the evolution of riskless interest rates. The model captures several stylized features such as a negative relation between equity prices and equity volatility, a negative relation between default intensity and equity prices, and a positive relationship between default intensity and equity volatility. We embed the model on a discrete-time, recombining lattice, making implementation feasible with polynomial complexity. We demonstrate the simplicity of calibrating the model to market data and of using it to extract default information. The framework is extensible to handling correlated default risk and may be used to value distressed convertible bonds, debt-equity swaps, and credit portfolio products such as collateralized debt obligations (CDOs). Applied to the CDX INDU (credit default index-industrials) Index, we find the S&P 500 index explains credit premia.

Keywords: securities, hybrid models, default, credit risk

JEL Classification: M41, G1, G12, C41, C52

Accepted Paper Series


Not Available For Download

Date posted: August 29, 2010 ; Last revised: March 14, 2011

Suggested Citation

Das, Sanjiv Ranjan and Sundaram, Rangarajan K., An Integrated Model for Hybrid Securities (September 1, 2007). Management Science, Vol. 53, No. 9, pp. 1439-1451, 2007. Available at SSRN: http://ssrn.com/abstract=1667082

Contact Information

Sanjiv Ranjan Das (Contact Author)
Santa Clara University - Leavey School of Business ( email )
Department of Finance
321E Lucas Hall
Santa Clara, CA 95053
United States
HOME PAGE: http://algo.scu.edu/~sanjivdas/
Rangarajan K. Sundaram
New York University (NYU) - Department of Finance ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0308 (Phone)
212-995-4233 (Fax)
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