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A Markov Chain Model with Stochastic Default Rate for Valuation of Credit Spreads

“The effort to bring default risk into our pricing paradigm is a major growth area within the field of derivatives. One of the newly standard approaches to this topic uses a Markov transition matrix to model the process of Òcredit migrationÓ across standard bond rating agency rating classes, and potentially into default. Early efforts along these lines produced unrealistic paths for bond yields, because credit spreads among rating classes were assumed to be fixed. KoderaÕs model introduces a time-varying risk of default, which produces much more familiar diffusion-like behavior for credit spreads. A practical application of the model illustrates the importance of spread volatility in pricing credit spread options.”