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The IUP Journal of Financial Risk Management :
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This paper presents an extended structural credit risk model that provides closed-form solutions for fixed and floating coupon bonds and credit default swaps. This structural model is an “extended” one, as it allows for the default-free term structure to be driven by a multifactor Gaussian model, rather than by a single factor model. Expected default occurs as a latent diffusion process first hits the default barrier, but the diffusion process is not the value of the firm’s assets. Liquidity risk is correlated with credit risk. Default can be “expected” or “unexpected”. And it is not necessary to disentangle the risk of “unexpected” default from liquidity risk. A tractable and accurate recovery assumption has been proposed in this paper.

This paper presents a tractable extended structural credit risk model that provides closed form solutions to price defaultable fixed and floating rate bonds and credit default swaps. This model extends the structural credit risk models in the literature. Most structural models assume that the default-free yield curve is described by one factor Vasicek model (1977). This does not seem satisfactory since the literature has clearly documented that multifactor models are needed to describe the dynamics of the defaultfree yield curve, e.g., Dai and Singleton (2002). Bakshi et al. (2006) recently found two latent factors driving default-free yields also enhance the empirical fit of their defaultable bond pricing model. Similarly, Hubner and Francois (2004) suggest that a two-factor default-free term structure model may also be appropriate to price defaultable bonds. The reduced form credit risk models also typically assume that default free yields are driven by two stochastic factors, e.g., Driessen (2005). Thus, the structural model in this paper assumes that the default-free yield curve is described by the three-factor Gaussian model of Babbs and Nowman (1999) which seems to fit the US Treasury yield curve quite well. A fully general Gaussian model as in Langetieg (1980); and Dai and Singleton (2002) could equally be assumed without affecting the model tractability.

 
 
 
 

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