An intensity model for credit risk with switching Lévy processes
Donatien Hainaut and
Olivier Le Courtois
Quantitative Finance, 2012, vol. 14, issue 8, 1453-1465
We develop a switching regime version of the intensity model for credit risk pricing. The default event is specified by a Poisson process whose intensity is modeled by a switching Lévy process. This model presents several interesting features. First, as Lévy processes encompass numerous jump processes, our model can duplicate the sudden jumps observed in credit spreads. Also, due to the presence of jumps, probabilities do not vanish at very short maturities, contrary to models based on Brownian dynamics. Furthermore, as the parameters of the Lévy process are modulated by a hidden Markov chain, our approach is well suited to model changes of volatility trends in credit spreads, related to modifications of unobservable economic factors.
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