Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds

Tim Xiao

EconStor Open Access Articles and Book Chapters, 2015, vol. 4, issue 1, 1-25

Abstract: This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.

Keywords: jump diffusion; convertible bond; convertible underpricing; convertible arbitrage; default time approach; default probability approach; asset pricing; credit risk modeling (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.econstor.eu/bitstream/10419/200122/1/p ... dJumpDiffusion-5.pdf (application/pdf)

Related works:
Working Paper: Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds (2017)
Working Paper: Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds (2017)
Working Paper: Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds (2017)
Journal Article: Is the jump-diffusion model a good solution for credit risk modelling? The case of convertible bonds (2015)
Working Paper: Is the jump-diffusion model a good solution for credit risk modelling? The case of convertible bonds (2015)
Working Paper: Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds (2013)
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:zbw:espost:200122

Access Statistics for this article

More articles in EconStor Open Access Articles and Book Chapters from ZBW - Leibniz Information Centre for Economics Contact information at EDIRC.
Bibliographic data for series maintained by ZBW - Leibniz Information Centre for Economics ().