Accounting to Acceptability: With Applications to the Pricing of Ones Own Credit Risk

20 Pages Posted: 28 Jan 2010 Last revised: 3 May 2010

See all articles by Ernst Eberlein

Ernst Eberlein

University of Freiburg

Thomas Gehrig

University of Vienna - Faculty of Business, Economics, and Statistics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Vienna Graduate School of Finance (VGSF); Systemic Risk Centre - LSE

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Date Written: November 30, 2009

Abstract

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

Eberlein, Ernst and Gehrig, Thomas and Madan, Dilip B., Accounting to Acceptability: With Applications to the Pricing of Ones Own Credit Risk (November 30, 2009). Robert H. Smith School Research Paper No. RHS 06-113. Available at SSRN: https://ssrn.com/abstract=1540778 or http://dx.doi.org/10.2139/ssrn.1540778

Ernst Eberlein

University of Freiburg ( email )

Department of Mathematical Stochastics
Eckerstrasse 1
D-79104, Freiburg
Germany
++49 761 203 5660 (Phone)
++49 761 203 5661 (Fax)

Thomas Gehrig

University of Vienna - Faculty of Business, Economics, and Statistics ( email )

Vienna, A-1210
Austria

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

Systemic Risk Centre - LSE ( email )

Houghton St, London WC2A 2AE, United Kingdom
London

Dilip B. Madan (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

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