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Continuous Monitoring: Does Credit Risk Vanish?1

  • Snorre Lindset (a1) and Svein-Arne Persson (a2)

We present a model for pricing credit risk protection for a limited liability non-life insurance company. The protection is typically provided by a guaranty fund. In the case of continuous monitoring, i.e., where the market values of the company's assets and liabilities are continuously observable, and where the market values of assets and liabilities follow continuous processes, regulators can liquidate the insurance company at the instant the market value of its assets equals the market value of its liabilities, implying that the credit protection is worthless. When jumps are included in the claims process, the protection provided by the guaranty fund has a strictly positive market value. The ability to continuously monitor asset prices with continuous sample paths eliminates economic losses from default. Our analysis suggests that economic losses from default stem from jumps in continuously observed asset prices and/or that asset prices are not continuously observed.

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Earlier versions of this paper have been presented at the FIBE conference in Bergen, January 2007, at the Astin Colloquium in Orlando, Florida, USA, June 2007, at faculty seminars at the Insurance and Risk Management Department at the Wharton School, University of Pennsylvania, the Department of Finance and Management Science, Norwegian School of Economics and Business Administration, and the University of Amsterdam. The paper was partially written while Lindset was a visiting scholar at the Insurance and Risk Management Department at the Wharton School, University of Pennsylvania. The authors would like to thank Knut Aase, Neil Doherty, Antoon Pelsser, and two anonymous referees for comments.

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This list contains references from the content that can be linked to their source. For a full set of references and notes please see the PDF or HTML where available.

J.D. Cummins (1988) “Risk-Based Premiums for Insurance Guaranty Funds”, Journal of Finance, 43(4), 823839.

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P. Jorion (1988) “On Jump Processes in the Foreign Exchange and Stock Markets”, Review of Financial Studies, 1(4), 427445.

S. Lindset (2007) “Pricing American Exchange Options in a Jump-diffusion Model”, Journal of Futures Markets, 27(3), 257273.

S. Lindset and S.-A. Persson (2006) “A Note on a Barrier Exchange Option: The World's Simplest Option Formula?”, Finance Research Letters, 3(3), 207211.

W. Margrabe (1978) “The Value of an Option to Exchange One Asset for Another”, Journal of Finance, 33, 177186.

R.C. Merton (1974) “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates”, Journal of Finance, 29(2), 449470.

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ASTIN Bulletin: The Journal of the IAA
  • ISSN: 0515-0361
  • EISSN: 1783-1350
  • URL: /core/journals/astin-bulletin-journal-of-the-iaa
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