On the Brody-Hughston-Macrina Approach to Modeling of Defaultable Term Structure

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On the Brody-Hughston-Macrina Approach to Modeling of Defaultable Term Structure

by Nannan Yu of the University of New South, and
Marek Rutkowski of the University of New South Wales & Warsaw University of Technology

December 5, 2005

Abstract: The innovative information-based framework for credit risk modeling, proposed recently by Brody, Hughston and Macrina, is extended to a more general and practically important set-up of random interest rates. We first introduce the market model and we derive an explicit expression for defaultable bond price. Next, the dynamics of the information process and dynamics of defaultable bond are found for both deterministic and random interest rates. Finally, the valuation and hedging of derivative securities are briefly examined. In particular, the valuation formula for a European option on a defaultable bond is established.

Keywords: credit risk, defaultable bond.

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