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| An Integrated Model for Hybrid Securities by Sanjiv R. Das of Santa Clara University, and October 2006 Abstract: We develop a model for pricing securities whose value may depend simultaneously on equity, interest-rate, and default risks. The framework may also be used to extract probabilities of default (PD) functions from market data. Our approach is based entirely on observables such as equity prices and interest rates, rather than on unobservable processes such as firm value. The model stitches together in an arbitrage-free setting a CEV equity model (to represent the behavior of equity prices prior to default), a default intensity process, and a Heath-Jarrow-Morton model for the evolution of riskless interest rates. The model captures several stylized features such as a negative relation between equity prices and equity volatility, a negative relation between default intensity and equity prices, and a positive relationship between default intensity and equity volatility. We embed the model on a discrete-time, recombining lattice, making implementation feasible with polynomial complexity. We demonstrate the simplicity of calibrating the model to market data, and of using it to extract default information. The framework is extensible to handling correlated default risk and may be used to value distressed convertible bonds, debt-equity swaps, and credit portfolio products such as CDOs. Applied to the CDX INDU Index, we find the S&P500 index explains credit premia. Forthcoming in: Management Science. Previously titled: "A Simple Model for Pricing Securities with Equity, Interest-Rate, and Default Risk" --and-- "A Simple Unified Model for Pricing Derivative Securities with Equity, Interest-rate, and Default Risk" Books Referenced in this Paper: (what is this?)
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