Pricing and Hedging of Credit Derivatives via the Innovations Approach to Nonlinear Filtering

Rüdiger Frey, Thorsten Schmidt

Publication: Scientific journalJournal articlepeer-review

Abstract

In this paper, we propose a new, information-based approach for modelling the dynamic evolution of a portfolio of credit risky securities. In our setup, market prices of traded credit derivatives are given by the solution of a nonlinear filtering problem. The innovations approach to nonlinear filtering is used to solve this problem and to derive the dynamics of market prices. Moreover, the practical application of the model is discussed: we analyse calibration, the pricing of exotic credit derivatives and the computation of risk-minimizing hedging strategies. The paper closes with a few numerical case studies.
Original languageEnglish
Pages (from-to)105 - 133
JournalFinance and Stochastics
Volume16
Issue number1
Publication statusPublished - 1 Mar 2012

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