Pricing to Acceptability: With applications to valuing ones own credit risk

The theory of pricing to acceptability developed for incomplete markets is applied to marking one’s own default risk. It is observed in agreement with Heckman (2004), that assets and liabilities are not to be valued in …nancial reporting at the same magnitude. Liabilities are to be marked at the ask prices of two price economies that are above the asset mark at the bid prices for such economies. Applying cones of acceptability de…ned by concave distortions it is observed that counterintuitive pro…tability resulting from credit deterioration is then mitigated. We argue that the di¤erence between the liability mark at two price ask and the asset mark at the two price bid be taken as an upfront expense deposited in a special account called the ODOR account for Own Default Operating Reserve. Procedures are described for pricing coupon bonds separately as assets and liabilities. These procedures employ the default time distribution embedded in the CDS market.