An application of time reversal to credit risk management

This article develops a new risk management framework.  We use time reversal, last passage time, and the h-transform of linear diffusions. For general diffusions with killing, we obtain the probability density of the last... [ view full abstract ]

This article develops a new risk management framework.  We use time reversal, last passage time, and the h-transform of linear diffusions. For general diffusions with killing, we obtain the probability density of the last passage time to a certain alarming level and analyze the distribution of the time left until killing after the last passage time to that level. We then apply these results to the leverage process of the company. Finally, we suggest how a company should determine the aforementioned alarming level. Specifically, we construct a relevant optimization problem and derive an optimal alarming level as its solution.