A general firm value model under partial information

Cheikh Mbaye, Abass Sagna and Frédéric Vrins
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Cheikh Mbaye: Université catholique de Louvain, LIDAM/LFIN, Belgium

No 2022009, LIDAM Discussion Papers LFIN from Université catholique de Louvain, Louvain Finance (LFIN)

Abstract: We introduce a new structural default model which purpose is to combine enhanced economic relevance and affordable computational complexity. Our approach exploits the information conveyed by a noisy observation of the firm value combined with the firm’s actual default state. Moreover, it is rather general since any diffusion can be used to depict the firm’s dynamics. However, this realistic setup comes at the expense of important computational challenges. To mitigate them, we propose an implementation based on recursive quantization. A thorough analysis of the approximation error resulting from our numerical procedure is provided. The power of our method is illustrated on the pricing of CDS options. This analysis reveals that the observation noise has a significant impact on the credit spreads’ implied volatility.

Keywords: Finance; credit risk; structural model; noisy information; non-linear filtering (search for similar items in EconPapers)
Pages: 27
Date: 2022-07-28
New Economics Papers: this item is included in nep-cfn and nep-rmg
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Related works:
Working Paper: A general firm-value model under partial information (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:ajf:louvlf:2022009

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