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Interacting default intensity with a hidden Markov process

Feng-Hui Yu, Wai-Ki Ching, Jia-Wen Gu and Tak Kuen Siu

Quantitative Finance, 2017, vol. 17, issue 5, 781-794

Abstract: In this paper we consider a reduced-form intensity-based credit risk model with a hidden Markov state process. A filtering method is proposed for extracting the underlying state given the observation processes. The method can be applied to a wide range of problems. Based on this model, we derive the joint distribution of multiple default times without imposing stringent assumptions on the form of default intensities. Closed-form formulas for the distribution of default times are obtained which are then applied to solve a number of practical problems such as hedging and pricing credit derivatives. The method and numerical algorithms presented can be applicable to various forms of default intensities.

Date: 2017
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DOI: 10.1080/14697688.2016.1237036

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