Modeling and Pricing Credit Risk in a Complex Environment

Fall 2022 Actuarial Science and Financial Mathematics Seminar

Date and Time: Friday, December 2, 2022, 2:00 PM (CST)

Speaker: Haibo Liu (University of Purdue)

Abstract: Consider a defaultable bond whose recovery rate in the event of default contains an exogenous (hence, unpredictable) component in addition to its contingency on the market performance until default. Suppose that the financial market is vulnerable to shock risk, which has impacts on the default intensity, the risk-free interest rate, the reference rate, and the regime switching in the market state. We conduct a pricing task of this defaultable bond. Our work is distinguished from most other works in that it captures three important features: exogenous shocks that affect every aspect of the bond, a regime-switching environment, and an unpredictable component embedded in the recovery rate. Assuming that the default intensity, the interest rate, and the reference rate jointly follow a general three-dimensional jump-diffusion process with coefficients governed by the regime of the market, we develop a risk-neutral pricing measure which prices the aforementioned risk sources in an integrated manner and hence entails a recovery risk premium. This pricing framework is directly applicable to credit derivatives in the presence of shock risk and unpredictable recovery.

About: Haibo Liu is an Assistant Professor of Actuarial Science at Purdue University. He earned his PhD degree from the University of Iowa in 2019. Prior to joining Purdue, he had worked as a Senior Research Associate at UNSW Sydney for 2 years. His current research interests include pricing in incomplete markets, insurance-linked securities and green bonds. He has published 9 papers in journals in actuarial science and the related fields including Insurance: Mathematics and Economics, Applied Mathematics and Computation, and European Journal of Operational Research.