Pricing and hedging credit-risky derivatives using corporate bonds

Murefu, Stephen Ngonidzashe

Pricing and hedging credit-risky derivatives using corporate bonds

Master Thesis

2003

Publisher

University of Cape Town

Department

School of Economics

Faculty

Faculty of Commerce

Abstract

The benefits of being a bondholder are well appreciated and documented in the world of investments. However, most of these holdings are in the risk free (no chances of defaulting) government bonds (Treasuries). It follows then that by investing in the riskier bonds (corporate bonds); the investor should reap more benefits (higher returns). The argument lies in the trade off, yield and risk. higher yield results in higher credit risk (the probability of default is higher). The answer is to invest in corporate bonds and simultaneously find ways to minimise the credit risk associated with those purchases. Credit derivatives (options in particular for this paper) are financial instruments that can aid in the management of credit risk by insuring against adverse movements in the credit quality of the borrower. That is. if the borrower defaults, the bondholder will incur loss on the bond investment but the losses can be offset by gains in the credit derivative. The credit risk can be fully offset on condition that the credit derivative is priced and hedged properly. This paper looks at the use of the Hull & White Model and the Jarrow & Turnbull Model to price and hedge credit risky options using corporate bonds and their comparable Treasury bonds. The models are taken from their papers. ""The Price of Default"", (1992) and ""Pricing Derivatives on Financial Securities Subject to Credit Risk"", (1995), respectively. Their models develop procedures to estimate the expected loss of default on a derivative using the price of risky debt issued by the counterparty in the derivative contract.

Description

Includes bibliographical references.

Keywords

Economics

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