Affine Modelling of Credit Risk, Pricing of Credit Events and Contagion
We propose a new discrete-time affine pricing model for defaultable securities breaking down the
most restrictive assumptions made in existing frameworks. Specifically, our model simultaneously
allows for (i) the presence of systemic entities by departing from the no-jump condition on the
factors’ conditional distribution, (ii) contagion effects, (iii) the pricing of credit events and (iv)
the presence of stochastic recovery rates. Our affine framework delivers explicit pricing formulas
for default-sensitive securities like bonds and credit default swaps. A first application shows how
this framework can be exploited to estimate sovereign credit risk premiums in an equilibrium
model. In a second application, we jointly model term structures of sovereign CDS denominated
in different currencies and extract market-implied probabilities of depreciations at default. A third
application illustrates the ability of the model to replicate the behavior of banks’ CDS spreads
that was observed in the aftermath of the Lehman Brothers’ bankruptcy