FIN-01-035

Pricing Credit Derivatives with Rating Transitions

November 5, 2001

Viral V. Acharya, Sanjiv Ranjan Das and Rangarajan K. Sundaram

ABSTRACT

We develop a model for pricing risky debt and valuing credit derivatives that is easily calibrated to existing variables. Our approach is based on expanding the Das and Sundaram (2000) extension of the Heath-Jarrow-Morton (1990) term-structure model to allow for multiple ratings classes of debt. The framework has two salient features: (i) it employs a ratings transition matrix as the driver or the default process, and (ii) the entire set of rating categories is calibrated jointly, allowing arbitrage-free restrictions across rating classes, as a bond migrates amongst them. We provide an illustration of the approach by applying it to price credit-sensitive notes that have coupon payments that are linked to the rating of the underlying credit.

Classification: G12, G13

Viral V. Acharya
Institution: Institute of Finance and Accounting, London Business School, 6 Sussex Place, Regent's Park London, NW1 4SA England
Telephone: 44-20-7262 5050 x. 3535
Fax: 44-20-7724 3317
Email: vacharya@london.edu
Homepage:http://www.stern.nyu.edu/~vacharya

Sanjiv Ranjan Das
Institution: Leavey School of Business, Santa Clara University, Santa Clara, CA 95053
Email: srdas@scu.edu

Rangarajan K. Sundaram
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0308
Fax: (212) 995-4233
Email: rsundara@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~rsundara

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