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Pricing Credit Derivatives with Rating Transitions

We present a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach expands a classical term-structure model to allow for multiple rating classes of debt. The framework has two salient features: (1) it uses a rating-transition matrix...

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Bibliographic Details
Published in:Financial analysts journal 2002-05, Vol.58 (3), p.28-44
Main Authors: Acharya, Viral V., Das, Sanjiv Ranjan, Sundaram, Rangarajan K.
Format: Article
Language:English
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Summary:We present a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach expands a classical term-structure model to allow for multiple rating classes of debt. The framework has two salient features: (1) it uses a rating-transition matrix as the driver for the default process, and (2) the entire set of rating categories is calibrated jointly, which allows arbitrage-free restrictions across rating classes as a bond migrates among them. We illustrate the approach by applying it to price credit-sensitive notes that have coupon payments linked to the rating of the underlying credit.
ISSN:0015-198X
1938-3312
DOI:10.2469/faj.v58.n3.2536