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A Shortcut Way of Pricing Default Risk Through Zero‐Utility Principle
Author(s) -
Tibiletti Luisa
Publication year - 2006
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/j.1539-6975.2006.00176.x
Subject(s) - zero (linguistics) , variance (accounting) , set (abstract data type) , risk premium , ask price , economics , variance risk premium , actuarial science , risk aversion (psychology) , econometrics , default risk , mathematical economics , expected utility hypothesis , credit risk , computer science , finance , volatility (finance) , philosophy , linguistics , accounting , volatility smile , volatility risk premium , programming language
Pricing the default risk is a hot challenge for every risk manager. The problem is tackled in the framework of the zero‐utility principle. According to Pratt (1964), an approximation of the risk premium should be proportional to the Arrow–Pratt absolute risk aversion coefficient and the variance. Is that still true as a default risk is concerned? The answer appears to be negative, because the variance does not look to be an appropriate tool for asymmetrical risk. On the other hand, fear of ruin coefficient and probability of default are proved to be well‐tailored tools for a preliminary pricing. Bid and ask price approximations are both elicited and a necessary condition for risk exchange set out.