Modelling Credit Risk in the Jump Threshold Framework. Issue 5 (2nd November 2018)

• Record Type: Journal Article
• Authors: Chiu, C.-Y.; Kercheval, A.
• Is Part Of: Applied mathematical finance. Volume 25:Issue 5/6(2018)
• Page Start: 411
• Page End: 433
• Publication Date: 2018-11-02
• Subjects: Credit risk -- Lévy processes -- affine processes; Business mathematics -- Periodicals; 650.0151
• DOI: 10.1080/1350486X.2018.1465349
• Languages: English
• ISSNs: 1350-486X

Abstract

ABSTRACT: The jump threshold framework for credit risk modelling developed by Garreau and Kercheval enjoys the advantages of both structural- and reduced-form models. In their article, the focus is on multidimensional default dependence, under the assumptions that stock prices follow an exponential Lévy process (i.i.d. log returns) and that interest rates and stock volatility are constant. Explicit formulas for default time distributions and basket credit default swap (CDS) prices are obtained when the default threshold is deterministic, but only in terms of expectations when the default threshold is stochastic. In this article, we restrict attention to the one-dimensional, single-name case in order to obtain explicit closed-form solutions for the default time distribution when the default threshold, interest rate and volatility are all stochastic. When the interest rate and volatility processes are affine diffusions and the stochastic default threshold is properly chosen, we provide explicit formulas for the default time distribution, prices of defaultable bonds and CDS premia. The main idea is to make use of the Duffie–Pan–Singleton method of evaluating expectations of exponential integrals of affine diffusions.