Pricing to acceptability: with applications to valuation of one’s own credit risk

Ernst Eberlein, Thomas Gehrig and Dilip B. Madan

Abstract

ABSTRACT

In this paper, the theory of pricing to acceptability developed for incomplete markets is applied to marking one's own default risk. Following the work of Heckman, it is observed that assets and liabilities are not to be valued identically in financial reporting. Liabilities are to be marked at the ask prices of two-price economies, which are above the asset mark at the bid prices for such economies. Applying cones of acceptability defined by concave distortions, it is observed that counterintuitive profitability resulting from credit deterioration is then mitigated. We argue that the difference between the liability mark at the two-price ask and the asset mark at the two-price bid should be taken as an upfront expense deposited in a special account called the own-default operating reserve account. Procedures are described separately for pricing coupon bonds as assets and liabilities. These procedures utilize the default time distribution embedded in the credit default swap market.