PRICING CDSS AND CDS OPTIONS UNDER A REGIME-SWITCHING CEV PROCESS WITH JUMP TO DEFAULT

Ruxing Xu (), Dan Wu () and Ronghua Yi ()
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Dan Wu: Department of Mathematics, China Jiliang University
Ronghua Yi: School of Management, China Jiliang University

ECONOMIC COMPUTATION AND ECONOMIC CYBERNETICS STUDIES AND RESEARCH, 2016, vol. 50, issue 1, 253-271

Abstract: This paper studies the valuation of credit default swaps (CDSs) and CDS options of European and Bermudan styles under a regimeswitching constant elasticity of variance (CEV) process with jump to default. Based on the empirical evidence that the changes of macroeconomic conditions such as business cycle impact on the values of credit products, we assume that the interest rate, the volatility parameter of the CEV process, and the parameters of default intensity function have switching dynamics governed by a continuous-time finite state Markov chain, whose states are deemed to represent the states of the underlying economy. We construct a recombining trinomial lattice and demonstrate the accuracy of the lattice framework. Within the framework, we derive the values of CDSs, European and Bermudan CDS options. The numerical results provide insight into the impact of regime switching on the behavior of CDS spread rates and the values of European and Bermudan CDS options.

Keywords: Credit default swap; CDS options; CEV process; Lattice model; Regime switching (search for similar items in EconPapers)
JEL-codes: C63 G13 (search for similar items in EconPapers)
Date: 2016
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