Empirical analysis and calibration of the CEV process for pricing equity default swaps

Belal Baaquie, Tang Pan and Jitendra Bhanap

Quantitative Finance, 2011, vol. 11, issue 12, 1815-1823

Abstract: Equity Default Swaps (EDSs) are credit-like instruments that were first introduced in 2003. EDSs are deep out of the money digital put options that pay out a fixed amount (recovery rate) upon the stock price hitting a pre-set low barrier. The premium is paid out as contingent quarterly payments similar to Credit Default Swaps (CDSs). EDSs initially soared in volume as investors used them in capital structure arbitrage strategies involving the simultaneous buying and selling of EDS contracts, as spreads on EDSs were several multiples of CDS spreads. However, the contracts diminished in volume as CDS contracts took over. With the recent financial turmoil in the credit derivatives market, some attention has turned from CDS and their associated structured correlation products such as Nth-to-default basket and synthetic Collateralized Debt Obligations (CDOs) as CDS markets tend to be opaque and difficult to price. In addition, default correlations are not directly observable and recoveries are stochastic, making pricing and modelling difficult. As against this, the underlying stock prices in EDS are directly observable and the correlation is also directly observable. The EDS may therefore return to the credit fold and may be a complement to the CDS market. In this paper, we examine the pricing of CDSs using the CEV process and calibrate the CEV process to actual observed market prices for EDS; we then draw conclusions on the CEV process, the relationship between stock prices and volatility, and the relationship between CDS and EDS prices.

Date: 2011
References: Add references at CitEc
Citations:

Downloads: (external link)
http://hdl.handle.net/10.1080/14697680903547915 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:taf:quantf:v:11:y:2011:i:12:p:1815-1823

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RQUF20

DOI: 10.1080/14697680903547915

Access Statistics for this article

Quantitative Finance is currently edited by Michael Dempster and Jim Gatheral

More articles in Quantitative Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().