Pricing transition risk with a jump-diffusion credit risk model: evidences from the CDS market

Giulia Livieri, Davide Radi and Elia Smaniotto

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Transition risk can be defined as the business-risk related to the enactment of green policies, aimed at driving the society towards a sustainable and low-carbon economy. In particular, when new green laws are released, companies are forced to comply with the new standards, incurring in costs which can undermine their financial stability. In this paper we derive formulas for the pricing of defaultable coupon bonds and Credit Default Swaps to empirically demonstrate that a jump-diffusion credit risk model in which the downward jumps in the firm value are due to tighter green laws can capture, at least partially, the transition risk. The empirical investigation consists in the model calibration on the CDS term-structure, performing a quantile regression to assess the relationship between implied prices and a proxy of the transition risk. Additionally, we show that a model without jumps lacks this property, confirming the jump-like nature of the transition risk.

Keywords: derivatives; climate change; hypothesis testing; panel data; asset pricing; CDS spreads; credit risk; sustainable finance; transition risk (search for similar items in EconPapers)
JEL-codes: C21 C32 G32 Q54 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2024-04-18
New Economics Papers: this item is included in nep-env and nep-rmg
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Published in Review of Corporate Finance, 18, April, 2024, 4(1–2), pp. 177 - 201. ISSN: 2693-9312

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