Credit gap risk in a first passage time model with jumps

Natalie Packham, Lutz Schloegl and Wolfgang M. Schmidt

Quantitative Finance, 2013, vol. 13, issue 12, 1871-1889

Abstract: The payoff of many credit derivatives depends on the level of credit spreads. In particular, credit derivatives with a leverage component are subject to gap risk, a risk associated with the occurrence of jumps in the underlying credit default swap spreads. In the framework of first passage time models, we consider a model that addresses these issues. The principal idea is to model a credit quality process as an Itô integral with respect to a Brownian motion with a stochastic volatility. Using a representation of the credit quality process as a time-changed Brownian motion, one can derive formulas for conditional default probabilities and credit spreads. An example for a stochastic volatility process is the square root of a L�vy-driven Ornstein--Uhlenbeck process. The model can be implemented efficiently using a technique called Panjer recursion. Calibration to a wide range of dynamics is supported. We illustrate the effectiveness of the model by valuing a leveraged credit-linked note.

Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Downloads: (external link)
http://hdl.handle.net/10.1080/14697688.2012.739729 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:taf:quantf:v:13:y:2013:i:12:p:1871-1889

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RQUF20

DOI: 10.1080/14697688.2012.739729

Access Statistics for this article

Quantitative Finance is currently edited by Michael Dempster and Jim Gatheral

More articles in Quantitative Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().