Article

A Guide to Modelling credit term Structures

Alexander Lipton and Andrew Rennie

in The Oxford Handbook of Credit Derivatives

Published in print January 2011 | ISBN: 9780199546787
Published online September 2012 | | DOI: http://dx.doi.org/10.1093/oxfordhb/9780199546787.013.0004

Series: Oxford Handbooks in Finance

 A Guide to Modelling credit term Structures

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This article examines the conventional bond pricing methodology and shows that it does not adequately reflect the nature of the credit risk faced by investors. In particular, it demonstrates that the strippable discounted cash flows valuation assumption, which is normally taken for granted by most analysts, leads to biased estimates of relative value for credit bonds. The article introduces a consistent survival-based valuation methodology that is free of biases, albeit at a price of abandoning the strippable discounted cash flows valuation assumption, and also develops a robust estimation methodology for survival probability term structures using the exponential splines approximation. This methodology is implemented and tested in a wide variety of market conditions, and across a large set of sectors and issuers, from the highest credit quality to highly distressed ones. It concludes that the adoption of the survival-based methodologies advocated in this article by market participants will lead to an increase in the efficiency of the credit markets, just as the adoption of better pre-payment models led to efficiency in the mortgage-based securities markets twenty years ago.

Keywords: valuation method; credit term structure; bond valuation; credit risk; survival-based valuation

Article.  24878 words. 

Subjects: Economics ; Financial Markets ; Econometric and Statistical Methods and Methodology: General

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