This paper makes two contributions to the literature. The first contribution is to investigate how to incorporate Markov-modulated Poisson processes with the reduced-form model to price risky securities. For its application, from the investor's point of view, since they do not have complete information about the operating condition of the reference entities, this pricing approach allows credit risk modeling when there is dependence between the default characteristics of reference entities and the unobservable status of operating condition. The higher transition rate from a good operating condition with lower default intensity to a bad one with higher default intensity is associated with higher default probability, and vice versa. Using the arbitrage-free valuation techniques, the second contribution of this article is to provide the closed-form pricing formulas for a variety of risky securities such as corporate debts, credit default swaps, credit linked notes, options on risky debts, risky convertible bonds, and the products with default correlations.
Advances in Quantitative Analysis of Finance and Accounting,7(7), 95-210