Time-changed CIR default intensities with two-sided mean-reverting jumps

Rafael Mendoza-Arriaga and Vadim Linetsky

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Abstract: The present paper introduces a jump-diffusion extension of the classical diffusion default intensity model by means of subordination in the sense of Bochner. We start from the bi-variate process $(X,D)$ of a diffusion state variable $X$ driving default intensity and a default indicator process $D$ and time change it with a L\'{e}vy subordinator ${\mathcal{T}}$. We characterize the time-changed process $(X^{\phi}_t,D^{\phi}_t)=(X({\mathcal{T}}_t),D({\mathcal{T}}_t))$ as a Markovian--It\^{o} semimartingale and show from the Doob--Meyer decomposition of $D^{\phi}$ that the default time in the time-changed model has a jump-diffusion or a pure jump intensity. When $X$ is a CIR diffusion with mean-reverting drift, the default intensity of the subordinate model (SubCIR) is a jump-diffusion or a pure jump process with mean-reverting jumps in both directions that stays nonnegative. The SubCIR default intensity model is analytically tractable by means of explicitly computed eigenfunction expansions of relevant semigroups, yielding closed-form pricing of credit-sensitive securities.

Date: 2014-03
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Citations: View citations in EconPapers (16)

Published in Annals of Applied Probability 2014, Vol. 24, No. 2, 811-856

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