hi how do you handle credit spread 1. For Option with Equity underlying 2. For Fixed Income/Bond
I understand there're two options: a. Expected Loss from Probability of Default & Recovery Rate (John Hull, chapter on credit risk) In the end, subtract from Bond Floor or Option value this "Expected Loss".
b. Shift Yield Curve (UP shift). You'd add "Credit Spread" to your yield curve (Unlike "Dividend Yield" handling where we subtract from rates)
i.e. Discount node values in tree at steeper rate, thus result in cheaper option value at root node for counter-party with higher credit spread.
Am I correct?