Dynamic Defaultable Term Structure Modeling Beyond the Intensity Paradigm

29 Pages Posted: 17 Jan 2018

See all articles by Frank Gehmlich

Frank Gehmlich

University of Freiburg

Thorsten Schmidt

University of Freiburg

Date Written: January 2018

Abstract

The two main approaches in credit risk are the structural approach pioneered by Merton and the reduced‐form framework proposed by Jarrow and Turnbull and by Artzner and Delbaen. The goal of this paper is to provide a unified view on both approaches. This is achieved by studying reduced‐form approaches under weak assumptions. In particular, we do not assume the global existence of a default intensity and allow default at fixed or predictable times, such as coupon payment dates, with positive probability. In this generalized framework, we study dynamic term structures prone to default risk following the forward‐rate approach proposed by Heath, Jarrow, and Morton. It turns out that previously considered models lead to arbitrage possibilities when default can happen at a predictable time. A suitable generalization of the forward‐rate approach contains an additional stochastic integral with atoms at predictable times and necessary and sufficient conditions for an appropriate no‐arbitrage condition are given. For efficient implementations, we develop a new class of affine models that do not satisfy the standard assumption of stochastic continuity. The chosen approach is intimately related to the theory of enlargement of filtrations, for which we provide an example by means of filtering theory where the Azéma supermartingale contains upward and downward jumps, both at predictable and totally inaccessible stopping times.

Keywords: credit risk, HJM, forward rate, structural approach, reduced‐form approach, Azéma supermartingale, affine processes, filtering

Suggested Citation

Gehmlich, Frank and Schmidt, Thorsten, Dynamic Defaultable Term Structure Modeling Beyond the Intensity Paradigm (January 2018). Mathematical Finance, Vol. 28, Issue 1, pp. 211-239, 2018, Available at SSRN: https://ssrn.com/abstract=3103375 or http://dx.doi.org/10.1111/mafi.12138

Frank Gehmlich (Contact Author)

University of Freiburg

Fahnenbergplatz
Freiburg, D-79085
Germany

Thorsten Schmidt

University of Freiburg ( email )

Fahnenbergplatz
Freiburg, D-79085
Germany

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