Under LIBOR Market Model Pricing Financialroduct with Default Risk
Date Issued
2009
Date
2009
Author(s)
Hsu, Chien-Chung
Abstract
Various derivative products have been issued in the market along with the development of financial environment. Interest rate-linked structured products are even more important as interest rate has been in low levels. However, past studies on pricing interest rate-linked structured products tend to ignore the default risk of the issuing institution itself. Hence, we will incorporate the credit risk into the pricing model. For the interest rate model, we choose the multifactor BGM market model which has been used broadly in practice. When taking the credit risk into consideration, David Li’s methodology tends to underestimate the long-term forward default probability of the issuing institution. The method of David Li creates the default curve by using the bond prices on the issuing date with corporate credit risk, and recursive formulas to find the default probability of the company in the future. When the duration of the structured product is long, the theoretical price of credit risk will be unreliable. Consequently, we implement the LIBOR market model presented by Scho ̈nbucher(2003) with default risk incorporated. We improved the default probability by using the concept of spot lognormal Forward-LOBOR Model to simulate the changes of the everyday default curve in the future, compared to David Li’s model which uses only one-day information to catch the default risk of the company of the following ten years. The results indicate that if we use the methodology presented in this paper, the long-term forward default probability will be obviously higher. It shows that we can price the Interest rate-linked structured products more reasonably by taking the default probability into account by utilizing the method introduced in this paper.
Subjects
Credit risk
default probability
Type
thesis
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