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.

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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.

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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?