A Direct Approach to Arbitrage-Free Pricing of Credit Derivatives1

27 Pages Posted: 7 Nov 2008

See all articles by Sanjiv Ranjan Das

Sanjiv Ranjan Das

Santa Clara University - Leavey School of Business

Rangarajan K. Sundaram

New York University (NYU) - Department of Finance

Date Written: November 1998

Abstract

This paper develops a framework for modelling risky debt and valuing credit derivatives that is exible and simple to implement, and that is, to the maximum extent possible, based on observables. Ourapproach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable debt. We do not follow the procedure of implying out the behavior of spreads from assumptions concerning the default process, instead working directly with the evolution of spreads. We show thatrisk-neutral drifts in the resulting model possess a recursive representation that particularly facilitates implementation and makes it possible to handle path-dependence and early exercise features without difficulty. The framework permits embedding a variety of specifications for default; we present an empirical example of a default structure which provides promising calibration results.

Suggested Citation

Das, Sanjiv Ranjan and Sundaram, Rangarajan K., A Direct Approach to Arbitrage-Free Pricing of Credit Derivatives1 (November 1998). NYU Working Paper No. FIN-99-013, Available at SSRN: https://ssrn.com/abstract=1296414

Sanjiv Ranjan Das (Contact Author)

Santa Clara University - Leavey School of Business ( email )

Department of Finance
316M Lucas Hall
Santa Clara, CA 95053
United States

HOME PAGE: http://srdas.github.io/

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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