Bjorn Flesaker (Bloomberg, NY)

Title: Replication based pricing of default contingent claims slide

The standard market model for single name credit default swap pricing is usually represented as a pure reduced form model where default occurs as the first jump of a Poisson process with deterministic risk neutral intensity. We provide conditions under which a static portfolio of standard credit default swaps along with a money market account balance can be used to replicate a broad class of default contingent claims and demonstrate that the resulting no-arbitrage values are consistent with the standard market model, regardless of the dynamics of the default generating process. The replication based pricing operator, as well as the associated survival contingent money market account balance and the replicating CDS portfolio positions, are fully characterized in terms of second order ordinary differential equations (for the continuous maturity limit) and difference equations (for discrete holdings), and examples of their explicit solutions are given.
This is based on joint work with Peter Carr.