A MARKOV MODEL FOR THE TERM STRUCTURE OF CREDIT RISK SPREADS

This article provides a Markov model for the term structure of credit risk; spreads. Tbe model is based on Jarrow and Turnbull (1995), with the bankruptcy process following a discrete state space Markov chain i n credit ratings. The parameters of this process are easily estimated using observable data. This model is useful for pricing and hedging co rporate debt with imbedded options, for pricing and hedging OTC deriva tives with counterparty risk for pricing and hedging (foreign) governm ent bonds subject to default risk (e.g., municipal bonds), for pricing and hedging credit derivatives, and for risk management.