A martingale representation theorem and valuation of defaultable securities

TL;DR

This paper develops a martingale representation theorem in a dual-information market model, enabling the decomposition of defaultable and mortality securities into orthogonal risk components without model restrictions.

Contribution

It introduces a novel optional martingale representation theorem applicable to large filtrations with random times, facilitating risk decomposition in credit and insurance markets.

Findings

Decomposition of martingales into orthogonal local martingales.

Application of the representation to defaultable and mortality securities.

Framework applicable to various financial and economic contexts.

Abstract

We consider a market model where there are two levels of information. The public information generated by the financial assets, and a larger flow of information that contains additional knowledge about a random time. This random time can represent many economic and financial settings, such as the default time of a firm for credit risk, and the death time of an insured for life insurance. By using the expansion of filtration, the random time uncertainty and its entailed risk are fully considered without any mathematical restriction. In this context with no model's specification for the random time, the main challenge lies in finding the dynamics and the structures for the value processes of defaultable or mortality and/or longevity securities which are vital for the insurance securitization. To overcome this obstacle, we elaborate our optional martingale representation results, which state that any martingale in the large filtration stopped at the random time can be decomposed into precise and unique orthogonal local martingales (i.e. local martingales whose product remains a local martingale). This constitutes our first and probably the principal contribution. Even though the driving motivation for this representation resides in credit risk theory, our results are applicable to several other financial and economics contexts, such as life insurance and financial markets with random horizon. Thanks to this optional representation, we decompose any defaultable or mortality and/or longevity liability into the sum of "non-correlated" risks using a risk basis. This constitutes our second contribution.