Recent Advances in Default Swap Valuation

Abstract

Valuing credit risk sensitive instruments is one of the major growth areas in derivatives research. Two main approaches are being thoroughly explored. Merton's „structural” approach models the stochastic evolution of total firm value, and default occurs if firm value hits a prespecified lower bound. In the „reduced form” approach, default is a random exogenous event, typically modeled as a Poisson process. The latter camp contains a variety of models that appear to handle the important parameters, jump intensity, the recovery rate in case of default, and riskless interest rates, very differently. In this article, Cheng presents a straightforward synthesis of the reduced form credit risk modeling framework and proves that the major existing models can all be seen as special cases of his general approach. This is extremely useful, both because it leads to a general valuation method, and also simply because it shows that the different existing models should all produce the same results with respect to such things as default probabilities implied by market prices for vulnerable instruments.