Time-Changed Birth Processes and Multiname Credit Derivatives

Xiaowei Ding (), Kay Giesecke () and Pascal I. Tomecek ()
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Xiaowei Ding: Department of Management Science and Engineering, Stanford University, Stanford, California 94305
Kay Giesecke: Department of Management Science and Engineering, Stanford University, Stanford, California 94305
Pascal I. Tomecek: J.P. Morgan Securities Inc., Quantitative Research, New York, New York 10017

Operations Research, 2009, vol. 57, issue 4, 990-1005

Abstract: A credit investor such as a bank granting loans to firms or an asset manager buying corporate bonds is exposed to correlated corporate default risk. A multiname credit derivative is a financial security that allows the investor to transfer this risk to the credit market. In this paper, we study the valuation and risk analysis of multiname derivatives. To capture the complex economic phenomena that drive the pricing of these securities, we introduce a time-changed birth process as a probabilistic model of correlated event timing. The self-exciting property of a time-changed birth process captures the feedback from events that is often observed in credit markets. The stochastic variation of arrival rates between events captures the exposure of firms to common economic risk factors. We derive a closed-form expression for the distribution of a time-changed birth process, and develop analytically tractable pricing relations for a range of multiname derivatives valuation problems. We illustrate our results by calibrating a tranche forward and option pricer to market rates of index and tranche swaps.

Keywords: finance; asset pricing; portfolio credit derivatives; financial institutions; banks; risk management; hedging; probability; self-exciting point processes; birth process; time change (search for similar items in EconPapers)
Date: 2009
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Citations: View citations in EconPapers (14)

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