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Tempered stable structural model in pricing credit spread and credit default swap

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  • Sung Ik Kim

    (Stony Brook University)

  • Young Shin Kim

    (Stony Brook University)

Abstract

In this paper, we explore the features of a structural credit risk model wherein the firm value is driven by normal tempered stable (NTS) process belonging to the larger class of Lévy processes. For the purpose of comparability, the calibration to the term structure of a corporate bond credit spread is conducted under both NTS structural model and Merton structural model. We find that NTS structural model provides better fit for all credit ratings than Merton structural model. However, it is noticed that probabilities of default derived from the calibration of the term structure of a bond credit spread might be overestimated since the bond credit spread could contain non-default components such as illiquidity risk or asymmetric tax treatment. Hence, considering CDS spread as a reflection of the pure credit risk for the reference entity, we calibrate it in order to obtain more reasonable probability of default and obtain valid results in calibration of the market CDS spread with NTS structural model.

Suggested Citation

  • Sung Ik Kim & Young Shin Kim, 2018. "Tempered stable structural model in pricing credit spread and credit default swap," Review of Derivatives Research, Springer, vol. 21(1), pages 119-148, April.
    • Handle: RePEc:kap:revdev:v:21:y:2018:i:1:d:10.1007_s11147-017-9135-5
    DOI: 10.1007/s11147-017-9135-5
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    1. Kim, Sung Ik, 2023. "A comparative study of firm value models: Default risk of corporate bonds," Finance Research Letters, Elsevier, vol. 56(C).

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    More about this item

    Keywords

    Normal tempered stable process; Structural model; Credit risk; Credit derivatives;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers

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