Title: Affine modelling of credit risk, pricing of credit events and contagion
Authors: Guillaume Roussellet - McGill University (Canada) [presenting]
Alain Monfort - ENSAE Paris (France)
Jean-Paul Renne - Banque de France (France)
Fulvio Pegoraro - European Central Bank and CREST (France)
Abstract: A new discrete-time affine pricing model for defaultable securities is proposed breaking down the most restrictive assumptions made in existing frameworks. Specifically, our model simultaneously allows for the presence of systemic entities by departing from the no-jump condition on the factors conditional distribution, contagion effects, the pricing of credit events and (iv)the presence of stochastic recovery rates. Our affine framework delivers explicit pricing formulas for default-sensitive securities like bonds and credit default swaps. A first application shows how this framework can be exploited to estimate sovereign credit risk premiums in an equilibrium model. In a second application, we jointly model term structures of sovereign CDS denominated in different currencies and extract market-implied probabilities of depreciations at default. A third application illustrates the ability of the model to replicate the behavior of banks CDS spreads that was observed in the aftermath of the Lehman Brothers bankruptcy.