An analytical GARCH valuation model for spread options with default risk

Shiyu Song, Dan Tang, Guangli Xu and Xunbai Yin

International Review of Economics & Finance, 2023, vol. 83, issue C, 1-20

Abstract: In this paper, an analytical pricing formula for spread options with credit default risk is derived. Assets are set within discrete-time CAPM markets and Heston–Nandi GARCH processes are adopted for capturing the variance dynamics of asset returns. The proposed model decomposes the risk of all assets into idiosyncratic and systematic parts, and considers the impacts on the default intensity of market fluctuations. A corresponding theoretical framework of discrete-time credit risk modeling in reduced-form is also provided. We incorporate the credit risk and systematic factor into an affine-GARCH valuation model and utilize Fourier transform techniques to obtain the analytic spread option prices. Finally, the empirical results and numerical analysis for different model parameters are displayed.

Keywords: GARCH; Spread options; Default risk (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:83:y:2023:i:c:p:1-20

DOI: 10.1016/j.iref.2022.08.013

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