Interest Rate Derivatives When Banks Are Risky
Geoff Harris
Stuart School of Business
Illinois Institute of Technology
Derivative contracts are valued using basic consistency arguments, as expressed by arbitrage pricing theory. Traditionally, in making these arguments, it is assumed that the participants in these agreements will be able to borrow and lend at the ‘risk-free rate’, with no significant possibility of default. With the advent of the credit crisis of 2007 – 2009, this assumption can no longer reasonably be made. We document how, because of this, traditional pricing models for interest rate derivatives lead to results that are inconsistent with market prices. We explore the implications of this on yield curve construction, and discuss simple stochastic models that incorporate the impact of credit risk on the pricing of simple interest rate derivatives.
This talk is based on research conducted by Geoffrey Harris, Tao Wu and Xuan Zhou, at the Stuart School of Business, IIT.