Credit risk & forward price models

Doutoramento em Gestão

This thesis consists of three distinct parts. Part I introduces the basic concepts and the notion of general quadratic term structures (GQTS) essential in some of the following chapters. Part II focuses on credit risk models and Part III studies forward price term structure models using both the classical and the geometrical approach. Part I is organized as follows. Chapter 1is divided in two main sections. The first section presents some of the fundamental concepts which are a pre-requisite to the papers that follow. All of the concepts and results are well known and hence the section can be regarded as an introduction to notation and the basic principles of arbitrage theory. The second part of the chapter is of a more technical nature and its purpose is to summarize some key results on point processes or differential geometry that will be used later in the thesis. For finite dimensional factor models, Chapter 2 studies GQTS. These term structures includeas special cases, the affine term structures and Gaussian quadratic term struc­ tures previously studied in the literature. We show, however, that there are other, non-Gaussian, quadratic term structures and derive sufficient conditions for the exis­ tence of these general quadratic term structures for zero-coupon bond prices. On Part II we focus on credit risk models. In Chapter 3 we propose a reduced form model for default that allows us to derive closed-form solutions for all the key ingredients in credit risk modeling: risk-free bond prices, defaultable bond prices (with and without stochastic recovery) and probabihties of survival. We show that all these quantities can be represented in general exponential quadratic forms, despite the fact that the intensity of default is allowed to jump pro­ducing shot-noise effects. In addition, we show how to price defaultable digital puts CDSs and options on defaultable bonds. Further on, we study a model for portfolio credit risk that considers both firm-specific and systematic risk. The model generalizes the attempt of Duffie and Garleanu (2001). We find that the model produces realistic default correlation and clustering effects. Next, we show how to price CDOs, options on CDOs and how to incorporate the link to currently proposed credit indices. In Chapter 4 we start by presenting a reduced-form multiple default type of model and derive abstract results on the influence of a state variable X on credit spreads when both the intensity and the loss quota distribution are driven by X. The aim is to apply the results to a real life situation, namely, to the influence of macroeconomic risks on the term structure of credit spreads. There is increasing support in the empirical literature for the proposition t at both the probability of default (PD) and the loss given default (LGD) are correlated and driven by macroeconomic variables. Paradoxically, there has been very little effort, from the theore:J;icalliterature, to develop credit risk models that would take this into account. One explanation might be the additional complexity this leads to, even for the "treatable" default intensity models. The goal of this paper is to develop the theoretical framework necessary to deal with this situation and, through numerical simulation, understand the impact of macroeconomic factors on the term structure of credit spreads. In the proposed setup, periods of economic depression are both periods of higher default intensity and lower recovery, producing a business cycle effect. Furthermore, we allow for the possibility of an index volatility that depends negatively on the index level and show that, when we include this realistic feature, the impacts on the credit spread term structure are emphasized. Part Ill studies forward price term structure models. Forward prices differ from futures prices in stochastic interest rate settings and become a.n. interesting object of study in their own right. Forward prices with di!ferent maturities are martingales under different forward mea­ sures. This mathematical property implies that the term structure of forward prices is always linked to the term structure of bond prices, and this dependence makes forward price .term structure models relatively harder to handle. For finite dimensional factor models, Chapter 5 applies the concept of 'GQTS to the term structure of forward prices. We show how the forward price term structure equa­ tion depends on the term structure of bond prices. We then exploit this connection and show that even in quadratic short rate settings we can have affine term structures for forward prices. Finally, we show how the study of futures prices is naturally embedded in the study of forward prices, that the difference between the two term structures ma.y be determin­ istic in some (non-trivial) stochastic interest rate settings. In Chapter 6 we study a fairly general Wiener driven modl for the term structure of forward prices. The model, under a fixed martingale measure, Q, is described by using two infinite dimensional stochastic differential equations (SDEs). The first system is a standard HJM model for (forward) interest rates, driven by a multidimensional Wiener process W. The second system is an infinite SDE for the term structure of forward prices on some specified underlying asset driven by the same W. Since the zero coupon bond volatilities will enter into the drift part of the SDE for these forward prices, the interest rate system is needed as input to the forward price system. Given this setup, we use the Lie algebra methodology of Bjork et al to investigate under what conditions, on the volatility structure of the forward prices and/or inter­ est rates, the inherently (doubly) infinite dimensional SDE for forward prices can be realized by a finite dimensional Markovian state space model.