November 1998
Sanjiv Ranjan Das, Rangarajan K. Sundaram
ABSTRACT
This paper develops a framework for modelling risky debt and valuing credit derivatives that is flexible
and simple to implement, and that is, to the maximum extent possible, based on observables. Our
approach is based on expanding the Heath-Jarrow-Morton term-structure model to allow for defaultable
debt. We do not follow the procedure of implying out the behavior of spreads from assumptions
concerning the default process, instead working directly with the evolution of spreads. We show that
risk-neutral drifts in the resulting model possess a recursive representation that particularly facilitates
implementation and makes it possible to handle path-dependence and early exercise features without
difficulty. The framework permits embedding a variety of specifications for default; we present an
empirical example of a default structure which provides promising calibration results.
Ranjan Das: sdas@hbs.edu
Sundaram: (212) 998-0308 rsundara@stern.nyu.edu
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