Corporate Credit Portfolio Pricing: A Cash Flow Based Multi-Period Credit Portfolio Model with Sationary Leverage Ratio Process

Most existing studies on portfolio credit model adopt either reduced form approach or multivariate extreme value theories. This study, alternatively, proposes a structure model that combines a cash flow based firm valuation and mean-reverting leverage ratios process in a multi-period corporate credit model. The cash flow based credit model with a factor structure is able to employ conditional independent default approach such as factor copula to analyze the credit risk of a corporate credit portfolio. This model improves the unrealistic assumption of Collin-Dufresne and Goldstein (CDG, 2001) that the firm’s capital structure decision is perfectly correlated to the firm’s value dynamics. The numerical example shows that our model generates better credit rating predicting than CDG (2001) model which also has a mean-reverting leverage ratio setting. In addition, the model can be applied to the valuation of a wide range of structured credit products and large sized debt portfolios, such as cash funded CBO and CDX.