FROM BID-ASK CREDIT DEFAULT SWAP QUOTES TO RISK-NEUTRAL DEFAULT PROBABILITIES USING DISTORTED EXPECTATIONS

Matteo Michielon, Asma Khedher () and Peter Spreij
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Matteo Michielon: ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands†Korteweg-de Vries Institute for Mathematics, University of Amsterdam, Science Park 105-107, 1098 XG Amsterdam, The Netherlands
Asma Khedher: #x2020;Korteweg-de Vries Institute for Mathematics, University of Amsterdam, Science Park 105-107, 1098 XG Amsterdam, The Netherlands
Peter Spreij: #x2020;Korteweg-de Vries Institute for Mathematics, University of Amsterdam, Science Park 105-107, 1098 XG Amsterdam, The Netherlands‡Institute for Mathematics, Astrophysics and Particle Physics, Radboud University Nijmegen, Huygens Building, Heyendaalseweg 135, 6525 AJ Nijmegen, The Netherlands

International Journal of Theoretical and Applied Finance (IJTAF), 2021, vol. 24, issue 03, 1-22

Abstract: Risk-neutral default probabilities can be implied from credit default swap (CDS) market quotes. In practice, mid-CDS quotes are used as inputs, as their risk-neutral counterparts are not observable. We show how to imply risk-neutral default probabilities from bid and ask quotes directly by means of formulating the CDS calibration problem to bid and ask market quotes within the conic finance framework. Assuming the risk-neutral distribution of the default time to be driven by a Poisson process we prove, under mild liquidity-related assumptions, that the calibration problem admits a unique solution that also allows to jointly calculate the implied liquidity of the market.

Keywords: Bid-ask spread; Choquet integral; concave distortion; conic finance; credit default swap; default probability; distorted expectation; index of acceptability; liquidity; reduced-form model; two-price economy (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1142/S0219024921500175

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