Default Process Modeling and Credit Valuation Adjustment

TL;DR

This paper introduces an integrated framework for modeling default processes and credit valuation adjustments, linking key credit risk metrics and simplifying risky valuation to standard valuation techniques, with results aligning with historical data.

Contribution

It provides a unified model connecting default risk metrics and simplifies credit valuation, addressing technical challenges in risky valuation.

Findings

Model prediction aligns with historical observations

Risky valuation reduces to ordinary valuation issues

Framework links default probability, survival, and correlation

Abstract

This paper presents a convenient framework for modeling default process and pricing derivative securities involving credit risk. The framework provides an integrated view of credit valuation adjustment by linking distance-to-default, default probability, survival probability, and default correlation together. We show that risky valuation is Martingale in our model. The framework reduces the technical issues of performing risky valuation to the same issues faced when performing the ordinary valuation. The numerical results show that the model prediction is consistent with the historical observations.