Shape Factor Models in Credit Risk

by Philip Gisdakis of the University of Oxford

December 21, 2004

Abstract: The shape factor model is a new type of term structure model. At first developed for interest rate risk, it can be expanded to cover credit risk, as well. The term structure of interest rates or credit spreads is modelled as a linear combination of basis functions (the shape factors) weighted by stochastic coefficients. As the comparison of a principle component analysis of the time series for CDS spreads of different companies reveals, the shape factor model allows to price credit risky securities with respect to the most important underlying risk driver, specific to each counterparty.

Furthermore, it offers an attractive platform to integrate credit and interest rate risk, and can be fitted to incorporate all relevant market data: interest rates and spread curves, current levels and historical time series, and finally, implied option volatilities. It is flexible and can be implemented for two, three, four or more underlying risk factors. Moreover, by switching between risk-neutral and physical probability measures investors can estimate the risk premium, which facilitates the investment.

Keywords: credit spread term structure model.

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