A simple model for credit migration and spread curves (Q2488476)

The authors propose and examine a simple model for credit migration and spread curves of a single firm both under real-world and risk neutral measures. The model is based on an affine three-dimensional state process \(Y\) that includes a possibility of a default. The default is triggered either by successive downgradings of the firm or an unpredictable jump of the state process. The default time is accordingly decomposed into predictable and totally inaccessible parts. The approach constitutes a hybrid of a structural and a reduced-form default time model. The novelty of the model lies in its explicit and tractable structure. An explicit expression for the real-world default probabilities is derived. The expressions for treasury and corporate bond prices with zero-recovery and fractional recovery in maturity are obtained. The zero-recovery yield spread curve is given as an explicit affine function of \(Y\). An equivalent change of measure which links the real-world and the risk-neutral model is provided.