Multiple ratings model of defaultable term structure

A new approach to modeling credit risk, to valuation of defaultable debt an d to pricing of credit derivatives is developed. Our approach, based on the Heath, Jarrow, and Morton (1992) methodology, uses the available informati on about the credit spreads combined with the available information about t he recovery rates to model the intensities of credit migrations between Var ious credit ratings classes. This results in a conditionally Markovian mode l of credit risk. We then combine our model of credit risk with a model of interest rate risk in order to derive an arbitrage-free model of defaultabl e bonds. As expected, the market price processes of interest rate risk and credit risk provide a natural connection between the actual and the marting ale probabilities.