On the Proxy Modelling of Risk-Neutral Default Probabilities

Abstract: Since the default of Lehman Brothers in 2008, it has become increasingly important to measure, manage and price the default risk in financial derivatives. Default risk in financial derivatives is referred to as counterparty credit risk (CCR). The price of CCR is captured in Credit Valuation Adjustment (CVA). This adjustment should in principle always enter the valuation of a derivative traded over-the-counter (OTC). To calculate CVA, one needs to know the probability of default of the counterparty. Since CVA is a price, what one needs is the risk-neutral probability of default. The typical way of obtaining risk-neutral default probabilities is to build credit curves calibrated using Credit Default Swaps (CDS). However, for a majority of a bank's counterparties there are no CDSs liquidly traded. This constitutes a major challenge. How does one model the risk-neutral default probability in the absence of observable CDS spreads? A number of methods for constructing proxy credit curves have been proposed previously. A particularly popular choice is the so-called Nomura (or cross-section) model. In studying this model, we find some weaknesses, which in some instances lead to degenerate proxy credit curves. In this thesis we propose an altered model, where the modelling quantity is changed from the CDS spread to the hazard rate. This ensures that the obtained proxy curves are valid by construction. We find that in practice, the Nomura model in many cases gives degenerate proxy credit curves. We find no such issues for the altered model. In some cases, we see that the differences between the models are minor. The conclusion is that the altered model is a better choice since it is theoretically sound and robust.