Credit risk analysis of mortgage loans: An application to the Italian market

The valuation of financial instruments in which both credit risk and interest rate risk are taken into account is an outstanding task for financial institutions. In this paper, we propose an affine-reduced model dealing with this topic. We show that this model offers analytical tractability as well as flexibility. We also show that the parameters of the model can be estimated via maximum likelihood in a straightforward way. To outline the procedure, we estimate the model on Italian data, using zero-coupon bond and historical default probabilities, as provided by the Bank of Italy.