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Pricing Derivatives on Financial Securities Subject to Credit Risk
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1995
Year
EconomicsFinancial EconomicsAsset PricingCorporate Risk ManagementFinancial Risk ManagementForeign Exchange OptionDerivative PricingManagementSpot Exchange RateBusinessNew MethodologyInternational Corporate FinanceCredit RiskFinance
Credit risk in derivatives arises when either the underlying asset or the derivative writer may default. The study introduces a new methodology for pricing and hedging derivative securities that incorporate credit risk. The authors use the foreign‑currency analogy of Jarrow and Turnbull (1991) to decompose a risky security’s dollar payoff into a certain component and a spot exchange rate, then apply arbitrage‑free valuation techniques. The method is applicable to corporate debt and OTC derivatives such as swaps and caps.
AbstractThis article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a spot exchange rate. Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps.