Risky caplet pricing with backward-looking rates

The Hull-White model for short rates is extended to include compounded rates and credit risk


Colin Turfus extends the Hull-White short-rate model to include the integrated short rate as a separate independent variable and to incorporate credit default risk, governed by a Black-Karasinski model, into cashflows. He derives an analytic representation of the associated pricing kernel, and applies it to the pricing of risky compounded interest rate payments that include caps and floors

It is by now well known that, in the wake of a number of scandals

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