Pricing Derivatives on Financial Securities Subject to Credit Risk

Posted: 10 May 2000

See all articles by Robert A. Jarrow

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business

Abstract

This paper provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a "spot exchange rate". Arbitrage free valuation techniques are then employed. This methodology can be applied to corporate debt and OTC derivatives, such as swaps and caps.

JEL Classification: G13

Suggested Citation

Jarrow, Robert A. and Turnbull, Stuart M., Pricing Derivatives on Financial Securities Subject to Credit Risk. JOURNAL OF FINANCE, VOL. 50, NO. 1, MARCH 1995, Available at SSRN: https://ssrn.com/abstract=5992

Robert A. Jarrow (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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