Tempered stable structural model in pricing credit spread and credit default swap

Sung Ik Kim () and Young Shin Kim ()
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Sung Ik Kim: Stony Brook University
Young Shin Kim: Stony Brook University

Review of Derivatives Research, 2018, vol. 21, issue 1, No 4, 119-148

Abstract: Abstract In this paper, we explore the features of a structural credit risk model wherein the firm value is driven by normal tempered stable (NTS) process belonging to the larger class of Lévy processes. For the purpose of comparability, the calibration to the term structure of a corporate bond credit spread is conducted under both NTS structural model and Merton structural model. We find that NTS structural model provides better fit for all credit ratings than Merton structural model. However, it is noticed that probabilities of default derived from the calibration of the term structure of a bond credit spread might be overestimated since the bond credit spread could contain non-default components such as illiquidity risk or asymmetric tax treatment. Hence, considering CDS spread as a reflection of the pure credit risk for the reference entity, we calibrate it in order to obtain more reasonable probability of default and obtain valid results in calibration of the market CDS spread with NTS structural model.

Keywords: Normal tempered stable process; Structural model; Credit risk; Credit derivatives (search for similar items in EconPapers)
JEL-codes: C58 E51 G12 G13 G31 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (1)

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DOI: 10.1007/s11147-017-9135-5

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