Accounting to Acceptability: With Applications to the Pricing of Ones Own Credit Risk
20 Pages Posted: 28 Jan 2010 Last revised: 3 May 2010
Date Written: November 30, 2009
The theory of pricing to acceptability developed for incomplete markets by Cherny and Madan (2009b) is applied to marking ones own default risk. It is observed in agreement with Heckman (2004), that assets and liabilities are not to be priced under fair value accounting principles at the same magnitude. Liabilities are marked at ask prices that are above the asset mark at bid prices. Applying cones of acceptability defined by the concave distortion minmaxvar at the stress level of 0.75 it is shown that counterintuitive profitability resulting from credit deterioration is eliminated. Following Heckman we suggest that the difference between the liability mark and the asset mark be taken as an upfront expense deposited in a special account called the ODOR account for Own Default Operating Reserve. Procedures for pricing coupon bonds separately as assets and liabilities are described. They employ the default time distribution as calibrated from the CDS market.
Keywords: Concave Distortions, Liability Pricing, Bid and Ask Prices
JEL Classification: G1, G12, G13
Suggested Citation: Suggested Citation