Security Pricing with Information-Sensitive Discounting

TL;DR

This paper develops incomplete-information models for pricing credit-risky securities with stochastic interest rates, incorporating economic and market information processes to derive pricing formulas for various financial instruments.

Contribution

It introduces information-sensitive pricing kernels that account for economic states and market factors, enabling valuation of complex securities under incomplete information.

Findings

Derived semi-analytical prices for credit-risky bonds.

Constructed recovery models based on economic states.

Valued hybrid securities like inflation-linked credit bonds.

Abstract

In this paper incomplete-information models are developed for the pricing of securities in a stochastic interest rate setting. In particular we consider credit-risky assets that may include random recovery upon default. The market filtration is generated by a collection of information processes associated with economic factors, on which interest rates depend, and information processes associated with market factors used to model the cash flows of the securities. We use information-sensitive pricing kernels to give rise to stochastic interest rates. Semi-analytical expressions for the price of credit-risky bonds are derived, and a number of recovery models are constructed which take into account the perceived state of the economy at the time of default. The price of European-style call bond options is deduced, and it is shown how examples of hybrid securities, like inflation-linked credit-risky bonds, can be valued. Finally, a cumulative information process is employed to develop pricing kernels that respond to the amount of aggregate debt of an economy.