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Nonhedgeable risk and Credit Risk Pricing

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  • Juan Dong
  • Lyudmila Korobenko
  • Deniz Sezer

Abstract

We introduce a new model for pricing corporate bonds, which is a modification of the classical model of Merton. In this new model, we drop the liquidity assumption of the firm's asset value process, and assume that there is a liquidly traded asset in the market whose value is correlated with the firm's asset value, and all portfolios can be constructed using solely this asset and the money market account. We formulate the market price of the corporate bond as the product of the price of an optimal replicating portfolio and exp(- kappa x replication error), where kappa is a positive constant. The interpretation is that the representative investor accepts the price of the optimal replicating portfolio as a benchmark, however, requests compensation for the non-hedgeable risk. We show that if the replication error is measured relative to the firm's value, the resulting formula is arbitrage free with mild restrictions on the parameters.

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  • Juan Dong & Lyudmila Korobenko & Deniz Sezer, 2019. "Nonhedgeable risk and Credit Risk Pricing," Papers 1910.08641, arXiv.org.
    • Handle: RePEc:arx:papers:1910.08641
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    References listed on IDEAS

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    7. Xin Guo & Robert A. Jarrow & Yan Zeng, 2009. "Credit Risk Models with Incomplete Information," Mathematics of Operations Research, INFORMS, vol. 34(2), pages 320-332, May.
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