A structural model for credit risk with switching processes and synchronous jumps

Donatien Hainaut and David Colwell
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Donatien Hainaut: ESC [Rennes] - ESC Rennes School of Business
David Colwell: The University of New South Wales

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Abstract: This paper studies a switching regime version of Merton's structural model for the pricing of default risk. The default event depends on the total value of the firm's asset modeled by a switching Lévy process. The novelty of this approach is to consider that firm's asset jumps synchronously with a change in the regime. After a discussion of dynamics under the risk neutral measure, two models are presented. In the first one, the default happens at bond maturity, when the firm's value falls below a predetermined barrier. In the second version, the firm can enter bankruptcy at multiple predetermined discrete times. The use of a Markov chain to model switches in hidden external factors makes it possible to capture the effects of changes in trends and volatilities exhibited by default probabilities. With synchronous jumps, the firm's asset and state processes are no longer uncorrelated. Finally, some econometric evidence that switching Lévy processes, with synchronous jumps, fit well historical time series is provided.

Date: 2014-06-18
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Published in European Journal of Finance, 2014, 22 (11), pp.1040-1062. ⟨10.1080/1351847X.2014.924079⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-04272406

DOI: 10.1080/1351847X.2014.924079

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