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Pricing credit derivatives under stochastic recovery in a hybrid model
Author(s) -
Höcht Stephan,
Zagst Rudi
Publication year - 2010
Publication title -
applied stochastic models in business and industry
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.413
H-Index - 40
eISSN - 1526-4025
pISSN - 1524-1904
DOI - 10.1002/asmb.792
Subject(s) - recovery rate , economics , credit risk , econometrics , credit derivative , default risk , process (computing) , computer science , actuarial science , chemistry , chromatography , operating system
In this article, a framework for the joint modelling of default and recovery risk is presented. The model accounts for typical characteristics known from empirical studies, e.g. negative correlation between recovery‐rate process and default intensity, as well as between default intensity and state of the economy, and a positive dependence of recovery rates on the economic environment. Within this framework analytically tractable pricing formulas for credit derivatives are derived. The stochastic model for the recovery process allows for the pricing of credit derivatives with payoffs that are directly linked to the recovery rate at default, e.g. recovery locks. Copyright © 2009 John Wiley & Sons, Ltd.