1. AN INFORMATION-BASED APPROACH TO CREDIT-RISK MODELLING by Matteo L. Bedini Universitè de Bretagne Occidentale Matteo.Bedini@univ-brest.fr

2. Agenda Credit Risk Credit Risk Credit Risk Credit Risk The Information-based Approach The Information-based Approach The Information-based Approach The Information-based Approach Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Derivatives and Coupon Bond Derivatives and Coupon Bond Derivatives and Coupon Bond Derivatives and Coupon Bond Considerations on the Model Considerations on the Model Considerations on the Model Considerations on the Model

3. Agenda Credit Risk Credit Risk The Information-based Approach The Information-based Approach Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Derivatives and Coupon Bond Derivatives and Coupon Bond Considerations on the model Considerations on the model

4. Credit Risk In financial markets credit risk is the risk associated to the possibility that a counterparty in a financial contract will not fulfill a contractual commitment to meet her/his obligation stated in the contract. EXAMPLES PARMALATLEHMAN BROTHERS Definition 4/31

5. Credit Risk Mathematical Finance and Credit Risk odelling: How is Credit Risk described? 1. Problem of modelling: How is Credit Risk described? Structural Models Structural Models Intensity Models Intensity Models Information-based Models Information-based Models : Given the model, how is a financial contract valuated? 2. Problem of valuating: Given the model, how is a financial contract valuated? Zero-Coupon Bond Zero-Coupon Bond Coupon Bond Coupon Bond Options Options Credit Default Swap Credit Default Swap … … 5/31

6. Credit Risk 1. Default-free interest rate system is deterministic. Basic Assumptions 2. Financial market is modelled through the specification of a probability space (the probability measure Q is the risk-neutral measure). 3. All processes are adapted to the market filtration. The existence of a unique risk-neutral measure is ensured, even if the market may be incomplete. 6/31

7. Credit Risk Under these hypothesis, if H T represents a cash-flow at time T > 0, then its value H t at time t < T is given by: EXAMPLE: Binary bond. Q(H T =h 1 )=p 1 (no default) Q(H T =h 0 )=p 0 =1-p 1 (default) General settings (1/2) 7/31

8. Credit Risk General settings (2/2) The random variable H T represents the final value of the defaultable bond. H T takes value h i with a priori probability p i (i=1,…,n): Q(H T =h i )=p i. At time t, the price B tT of a defaultable bond with maturity T>0, is given by: The purpose is to obtain the bond price process: 8/31 A defaultable bond is a financial contract that, at a pre-specified instant of time (maturity), delivers to the owner a certain amount of money, if the default never occurs.

9. Agenda Credit Risk Credit Risk The Information-based Approach The Information-based Approach Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Derivatives and Coupon Bond Derivatives and Coupon Bond Considerations on the Model Considerations on the Model

10. The Information-based Approach There exist an F t -adapted process accessible to market agents, modelling the flow of information concerning future cash-flow of the defaultable bond: The information-process (1/2) σ is a constant (information parameter). H T is an F T -measurable random variable. β tT is a standard Brownian bridge on [0, T] independent from H T (it is F T - measurable! ). 10/31 Theorem: ξ t satisfies the Markov property.

11. The Information-based Approach The information-process (2/2) t=0: all the information is in the a priori probability distributions t in (0,T): news, rumors, stories and speculation are mixed together, building the information about H T arriving on the market. t=T: the moment of truth. 11/31

12. The Information-based Approach Bond Price Process Simplifying assumption: the subalgebra generated by the information process ξ t is the market filtration: 12/31

13. The Information-based Approach Bayes formula 13/31

14. The Information-based Approach Bond price process Next step: obtain the defaultable bond dynamics dB tT = ? 14/31

15. Agenda Credit Risk Credit Risk The Information-based Approach The Information-based Approach Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Derivatives and Coupon Bond Derivatives and Coupon Bond Considerations on the Model Considerations on the Model

16. Defaultable Discount Bond Dynamics The Brownian motion Theorem: W t is an F t -Brownian motion. 16/31 The conditional probability:

17. Defaultable Discount Bond Dynamics Dynamics 17/31 Bond price dynamics: The short rate: Absolute bond volatility: Conditional variance:

18. Defaultable Discount Bond Dynamics Simulations of a digital bond. 18/31 σ=35%σ=55% σ=75%σ=95%

19. Agenda Credit Risk Credit Risk The Information-based Approach The Information-based Approach Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Derivatives and Coupon Bond Derivatives and Coupon Bond Considerations on the Model Considerations on the Model

20. Derivatives and Coupon Bond An European call option is a financial contract that gives the owner the right to buy a pre-specified asset (the underlying) at a pre-specified price (the strike price) at a given instant of time. European call option (1/3) T is the maturity of the defaultable bond. t is the maturity of the option. K is the strike price. 20/31

21. Derivatives and Coupon Bond European call option (2/3) 21/31

22. Derivatives and Coupon Bond European call option (3/3) 22/31 Change of measure by using factor Φ t : from measure Q to measure B (the bridge measure). Binary case (i=1):

23. Derivatives and Coupon Bond Numerical results 23/31 Call option: C 0 = f( B 0 )Put option: P 0 = f( B 0 ) Call option: Δ=∂C 0 / ∂ B 0 Call option: Vega=∂C 0 / ∂σ

24. Derivatives and Coupon Bond The X-factor Approach 24/31 Modeling more complex situations: how to describe multiple cash-flow? Idea: if we have n cash-flows, each at time T i, we can built n information processes ξ (i), i=1,…,n, describing the information regarding the corresponding cash-flows.

25. Derivatives and Coupon Bond Credit Default Swap 25/31 A Credit Default Swap (CDS) is a credit derivative between two counterparties, whereby one makes periodic payments (g) to the other and receives the promise of a payoff (h) if a third party defaults. The former party receives credit protection and is said to be the buyer while the other party provides credit protection and is said to be the seller. The third party is known as the reference entity. It often happen that the coupon g and the payoff h are chosen in such way the value V t of the CDS at time t=0 is V 0 =0. (*) In the first formula X tT0 = 1 for convenience (*)

26. Derivatives and Coupon Bond Coupon Bond 26/30 A Coupon Bond is a contract between a buyer and a seller in which at time t=0 the buyer gives to the seller p euro (principal). The seller will pay to the buyer at some pre-specified dates T 1,…, T n a pre-specified amount of money (coupon) c i, i=1,…, n, and at time T n the seller will pay even the principal p.

27. Derivatives and Coupon Bond Numerical simulations 27/31 Simulation of the dynamics of a 5-years CDS. Earnings are positive for the seller of protection. Simulation of the dynamics of a 5-years Coupon Bond.

28. Agenda Credit Risk Credit Risk The Information-based Approach The Information-based Approach Defaultable Discount Bond Dynamics Defaultable Discount Bond Dynamics Derivatives and Coupon Bond Derivatives and Coupon Bond Considerations on the Model Considerations on the Model

29. Consideration on the Model Further development 29/31 Stochastic default-free interest rate system Stochastic default-free interest rate system Final cash-flow (H T ) dependent from the “noise” Final cash-flow (H T ) dependent from the “noise” Generalized noise process Generalized noise process

30. Consideration on the Model Conclusion 30/31 A new class of models for Credit-risk has been analyzed. Central role of the information arriving on the market. It is possible to obtain bond price process (relating the a priori probability with the a posteriori). Explicit formula for bond price dynamics. Possibility of pricing derivatives (vanilla options, CDS, …).

31. Bibliography 31/31 D. C. Brody, L. P. Hughston & A. Macrina. Beyond Hazard rates: a new framework for credit risk modelling. Advances in Mathematical Finance, Festschrift volume in honour of Dilip Madan. Birkhauser, Basel, 2007. T. R. Bielecki and M. Rutkowski. Credit Risk: Modelling, Valuation and Hedging. Springer, 2002. P. J. Schonbucher. Credit Derivatives Pricing Models. John Wiley & Sons, 2003 T. R. Bielecki, M. Jeanblanc, and M. Rutkowski. Modelling and valuation of credit risk. In Stochastic Methods in Finance, Bressanone Lectures 2003, eds. M. Frittelli and W. Runggaldier, LNM 1856, Springer 2004. D. Lando. Credit Risk Modelling. Princeton University Press, 2004. M. Rutkowski and N. Yu. An extension of the Brody-Hughston-Macrina approach to modelling of defaultable bonds. Int. J. Theor. Appl. Fin. 10, 557-589, 2007. D. C. Brody, M. H. A. Davis, R. L. Friedman, L. P. Hughston, Informed traders. Working paper, 2008.. D. C. Brody, L. P. Hughston & A. Macrina. Information-based asset pricing. International Journal of Theoretical and Applied Finance. 2008, vol. II, issue 01, pages 107-142.

32. THANK YOU VERY MUCH ! Grazie mille !