An Integrated Pricing Model for Defaultable Loans and Bonds

Abstract

During the last two years, credit risk has been playing a key role in risk management issues. Practitioners, academics and regulators have been fully involved in the process of developing, studying and analysing credit risk models in order to find the elements, which characterize a sound risk management system. In this paper we present an integrated model, based on a reduced form pricing, for market and credit risk and its main features are those of being mark to market and that the spread term structure by rating class is adjusted for a spread term structure which is contingent on the seniority of debt within an arbitrage-free framework. We introduce issues such as, the integration of market and credit risk, the use of stochastic recovery rates and recovery by seniority. Moreover, we will characterise default risk by estimating migration risk through a 'mortality rate' - actuarial based - approach. The resultant probabilities will be the base for determining multi-period risk-neutral transition probability that allow to price risky debt trading and banking book plain vanilla type securities.

Keywords: statistical simulation methods, financial risk management, credit risk measurement model, pricing models, debt & debt management, portfolio choice

JEL Classification: C15, C69, H63, G11