| The exponential-affine class of reduced form models has been widely used to price the credit risk of defaultable assets. For example, Duffee (1999) uses a three-factor process to fit corporate bond prices. However, little has yet been done in comparing the performances of different reduced form models in the pricing of defaultable assets. Besides, most of the empirical research fails to address the impacts brought about by the misspecification errors in the default-free term structure. Moreover, unlike the structural approach, little has yet been done in using the reduced form model as a portfolio risk management tool.; In this thesis, I propose an alternative model in which there is no arbitrage opportunity in the default-free term structure and at the same time the tractability of the pricing equations can be maintained. Empirical tests suggest that this new model outperforms the commonly used exponential-affine models, resulting in both a smaller error in yield and better tracking ability. The benefit is found to be most profound in the pricing of bonds with low credit ratings and bonds of either short or long maturities.; For the purpose of credit risk management, I propose a multi-firm reduced form model and suggest an inexpensive way to use it to measure portfolio credit risk. I calibrate and back-test the model using corporate bond prices. The empirical results suggest that credit risk is highly systematic, especially for firms with low credit ratings. Moreover, discontinuity in hazard rate is needed to capture the occurrence of extreme loss events.; In the last chapter of this thesis, I turn my attention to the price recovery and information dissemination process. I develop a game theoretic model to describe the market microstructure of trading a risky asset with fixed time-to-maturity. This model is flexible enough to accommodate both the information asymmetry and inventory control features. Information asymmetry arisen in the sense that the private signal of the monopolistic market maker is more accurate than that of the investors. One of the main implications of the model is that the optimal bid-ask spread decreases as information superiority of the market maker increases. |
