Pricing Defaultable Bonds Using a Lévy Jump‐Diffusion Model

Shu L. Chiang and Ming S. Tsai

International Review of Finance, 2019, vol. 19, issue 3, 613-640

Abstract: This paper uses a reduced‐form approach to derive a closed‐form pricing formula for defaultable bonds. The authors specify the default hazard rate as an affine function of multiple variables which follow the Lévy jump‐diffusion processes. Because such specification allows greater flexibility in the generation of a valid probability of default, their pricing model should be more accurate than the valuation models in traditional studies, which ignore the jump effects. This paper also proposes a new method for estimating the parameters in a Lévy Jump‐diffusion process. The real data from the Taiwanese bond market are used to illustrate how their model can be applied in practical situations. The authors compare the pricing results for the influential variables with no jump effects, with jump magnitudes following the normal distribution, and with jump magnitudes following the gamma distribution. The results reveal that the predictive ability is the best for the model with the jump components. The valuation model shown in this paper should help portfolio managers more accurately price defaultable bonds and more effectively hedge their portfolio holdings.

Date: 2019
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International Review of Finance is currently edited by Bruce D. Grundy, Naifu Chen, Ming Huang, Takao Kobayashi and Sheridan Titman

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