Working Paper: CEPR ID: DP3329
Authors: Viral V. Acharya; Sanjiv Ranjan Das; Rangarajan K. Sundaram
Abstract: We develop a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach is based on expanding the Heath-Jarrow-Morton (1990) term-structure model and its extension, the Das-Sundaram (2000) model to allow for defaultable debt with rating transitions. The framework has two salient features, comprising extensions over the earlier work: (i) it employs a rating transition matrix as the driver for the default process, and (ii) the entire set of rating categories is calibrated jointly, allowing, with minimal assumptions, arbitrage-free restrictions across rating classes, as a bond migrates amongst them. We provide an illustration of the approach by applying it to price credit sensitive notes that have coupon payments that are linked to the rating of the underlying credit.
Keywords: credit derivatives; credit sensitive note; HJM model; rating transitions; risky debt
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| rating transitions (R50) | pricing of credit derivatives (G13) |
| credit rating changes (G21) | credit spread (G19) |
| credit spread (G19) | pricing of risky debt instruments (G12) |
| credit ratings (G24) | pricing of credit derivatives (G13) |