Assessing Credit with Equity: A CEV Model with Jump to Default

Luciano Campi (), Simon Polbennikov () and Sbuelz ()
Additional contact information
Luciano Campi: CEREMADE, Université Paris Dauphine
Simon Polbennikov: Econometrics and Operations Research, Tilburg University, The Netherlands,
Sbuelz: Department of Economics (University of Verona)

No 24/2005, Working Papers from University of Verona, Department of Economics

Abstract: Unlike in structural and reduced-form models, we use equity as a liquid and observable primitive to analytically value corporate bonds and credit default swaps. Restrictive assumptions on the firm’s capital structure are avoided. Default is parsimoniously represented by equity value hitting the zero barrier. Default can be either predictable, according to a CEV process that yields a positive probability of diffusive default and enables the leverage effect, or unpredictable, according to a Poisson-process jump that implies non-zero credit spreads for short maturities. Easy cross-asset hedging is enabled. By means of a carefully specified pricing kernel, we also enable analytical credit-risk management under possibly systematic jump-to-default risk.

Keywords: Equity; Corporate Bonds; Credit Default Swaps; Constant-Elasticity-of-Variance (CEV) Diffusion; Jump to Default (search for similar items in EconPapers)
JEL-codes: G12 G33 (search for similar items in EconPapers)
Pages: 40
Date: 2005-09
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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