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Lecture 3 - Intensity Based Models

1) The document discusses intensity-based models for credit risk modeling. Intensity refers to the probability of default occurring in a small interval of time. 2) Common intensity-based models include Poisson models, where default arrivals follow a Poisson process, and double stochastic or Cox models where the intensity varies stochastically over time. 3) The credit spread can be modeled as the intensity in these frameworks. The survival probability is derived using the intensity.

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62 views

Lecture 3 - Intensity Based Models

1) The document discusses intensity-based models for credit risk modeling. Intensity refers to the probability of default occurring in a small interval of time. 2) Common intensity-based models include Poisson models, where default arrivals follow a Poisson process, and double stochastic or Cox models where the intensity varies stochastically over time. 3) The credit spread can be modeled as the intensity in these frameworks. The survival probability is derived using the intensity.

Uploaded by

PARTH
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Intensity Based Models

Advanced Methods of Risk Management


Umberto Cherubini
Learning Objectives

In this lecture you will learn


1. The concept of hazard rate and of intensity
2. Model the dynamics of intensity (Poisson,
double stochastic models and Cox models)
3. Extending the model to include positive
recovery rates
4. Models incorporating loss-given-default in
market data.
5. Calibrating intensities from market data.
Reduced form models

In the reduced form models, default probability and


recovery rate (LGD) are modelled based on statistical
assumptions instead of an economic model of the
firm.
The modelling techniques that are used are very
close to those applied in insurance mathematics,
specifying the frequency of occurrence of the event
(default probability) and the severity of loss in case
the event takes place (loss given default)
These models use then the concept of intensity and
for this reason are also called intensity based
Credit spread and survival analysis

Denote, in a structural model, Q the probability of


survival of the obligor after the maturity of the
obligation, (the default probability is then DP = 1 Q)
and LGD the loss given default figure. Then, the
credit spread is given by
Credit Spread = ln[1 (1 Q )LGD]/(T t)
Assume now the most extreme case in which all the
exposure is lost (LGD = 1). We have
Credit Spread = ln[Q]/(T t)
Models from survival analysis (actuarial science) can
help design the credit spread.
Hazard rates

Consider the conditional default


probability
Qt Qt 1 Qt
h(t ) lim
0 Qt Qt
t
Qt exp hu du
0
Poisson model

Assume the default event to be drawn from a Poisson


distribution (remember that it describes the
probability of a countable set of events in a period of
time).
The Poisson distribution is characterized by a single
parameter, called intensity. The probability that no
event takes place before time T (in our case meaning
survival probability beyond that)is given by the
formula
Prob( > T) = exp ( (T - t))
Constant intensity model

Applying the survival probability function


Q = Prob( > T) = exp ( (T - t))
to the credit spread formula (again
under the assumption LGD = 1)
Credit Spread = ln[Q]/(T t)
we get
Credit Spread =
Intensity vs structural

Intensity denotes the probability of an event


in an infinitesimal interval of time. The
expected time before occurrence of the event
is 1/.
Differently from structural models, the default
event comes as a surprise. Technically, it is
said that default is an inaccessible time.
The intensity corresponds to the concept of
instantaneous forward rate in interest rate
models.
Double stochastic models

If the intensity parameter is not fixed, but changes


stochastically with time, the model is called Cox
model (or double stochastic models)
For every maturity we can consider an average
intensity (t,T) and the credit spread curve will be
Credit Spread(t,T) = (t,T)
Notice that the relationship between , that is the
instantaneous intensity, and the average intensity is
the same as that between instantaneous spot rate
and yield to maturity in term structure models
Survival probability

The survival probability beyond time T is


recovered simply using the zero coupon
bond formula

T
P T E exp u du

0
Affine models

Assume the dynamics of default intensity is


described by a diffusive process like
d (t) = k( (t))dt + dz(t)
where setting = 0, 0.5 deliver standard
affine term structure models for the credit
spread
Debt(t,T) = v(t,T)exp(A(T-t) - B(T -t) (t))
with A and B the affine functions in Vasicek (
= 0) or Cox Ingersoll Ross ( = 0.5) models
Positive recovery rate
If we assume positive recovery rate (and so LGD < 1)
and independence between interest rate in default
intensity we can easily extend the analysis. Denote
the recovery rate and compute
Debt(t,T; )=v(t,T)[Prob( > T)+ Prob( T)]
Debt(t,T; )= v(t,T) +(1-) Prob( >T)v(t,T)
Debt(t,T; 0)= Prob( >T)v(t,T), from which...
Debt(t,T; )= v(t,T) +(1-) D(t,T; 0)
The price is obtained as a portfolio of the risk free
asset and a defaultable exposure with recovery rate
zero.
Default probabilities

The spread of a BBB 10 exposure over the risk-free


yield curve is 45 basis points.
Assuming zero recovery rate we get
Prob( >T) = exp ( .0045 10) = 0.955997
and the probability of default is
1 - 0.955997 = 4.4003%
Assuming a 50% recovery rate we have
Prob( >T) = [exp ( .0045 10) - ]/(1- ) =
0.911995
and default probability is 1 - 0.911995 = 8.8005%
Simulating default times

F(T1) = P( > T1) = exp( T1) = u which


is uniformly distributed
Generate: u = rnd()
Compute T1 = F-1(u) = ln(u)/
For double stochatic models: first
simulate the trajectory of (t)
Stochastic interest rates

Assume discrete time model, time span , stochastic


interest rate and loss given default defined in terms of
market value. R risky rate, r riskless rate
1

1
1 L 1
1 R 1 r
r L
R
1 L
r L
lim R r L r *
0 1 L

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