I heard some very good seminars in the last few days on credit modeling. But after my excitement at understanding something I didn’t understand before, I get a slight touch of the blues. There’s this one dominant theme to financial modeling:
* pick a plausible stochastic process with parameters;
* calculate the value of securities whose prices you know;
* fix the parameters to match those prices;
* use the model to calculate values of other securities.
Every ten years the process repeats itself:
* stock options: match stock and bond, fix volatility;
* interest rates: match bond or swap prices, fix volatilities;
* credit: match CDS prices, fix future default probabilities.
When you get more sophisticated, you make the parameters you fixed also stochastic. Hence stochastic volatility, stochastic default probabilities, …
Cf. Peggy Lee: Is that all there is?