Chapter 17

Credit Spread Fitting and Modeling

Chapter 16 provided an extensive introduction to reduced form credit modeling techniques. In this chapter, we combine the reduced form credit modeling techniques with the yield curve smoothing techniques of Chapter 5 and related interest rate analytics in Chapters 6 through 14. As emphasized throughout this book, we need to employ the credit models of our choice as skillfully as possible in order to provide our financial institution with the ability to price credit risky instruments, to calculate their theoretical value in comparison to market prices, and to hedge our exposure to credit risk. The most important step in generating this output is to fit the credit models as accurately as possible to current market data.

If we do this correctly, we can answer these questions:

  • Which of the 15 bonds outstanding for Ford Motor Company is the best value at current market prices?
  • Which of the 15 bonds should I buy?
  • Which should I sell short or sell outright from my portfolio?
  • Is there another company in the auto sector whose bonds provide better risk-adjusted value?

Answering these questions is the purpose of this chapter. We continue to have the same overall objective: to accurately measure and hedge the interest rate risk, market risk, liquidity risk, and credit risk of the entire organization using the Jarrow-Merton put option concept as our integrated measure of risk.

INTRODUCTION TO CREDIT SPREAD SMOOTHING

The accuracy of yield curve ...

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