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Stochastic Volatility Effects on Defaultable Bonds

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Author Info

  • Jean-Pierre Fouque
  • Ronnie Sircar
  • Knut S�lna
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    Abstract

    This paper studies the effect of introducing stochastic volatility in the first-passage structural approach to default risk. The impact of volatility time scales on the yield spread curve is analyzed. In particular it is shown that the presence of a short time scale in the volatility raises the yield spreads at short maturities. It is argued that combining first passage default modelling with multiscale stochastic volatility produces more realistic yield spreads. Moreover, this framework enables the use of perturbation techniques to derive explicit approximations which facilitate the complicated issue of calibration of parameters.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/13504860600563127
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

    Volume (Year): 13 (2006)
    Issue (Month): 3 ()
    Pages: 215-244

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    Handle: RePEc:taf:apmtfi:v:13:y:2006:i:3:p:215-244

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    Web page: http://www.tandfonline.com/RAMF20

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    Related research

    Keywords: First-passage structural approach; stochastic volatility; time scales; yield spreads; calibration;

    References

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    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    2. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-64, May.
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    Cited by:
    1. Andreou, Elena & Ghysels, Eric, 2008. "Quality control for structural credit risk models," Journal of Econometrics, Elsevier, vol. 146(2), pages 364-375, October.
    2. Masaaki Fukasawa, 2011. "Asymptotic analysis for stochastic volatility: martingale expansion," Finance and Stochastics, Springer, vol. 15(4), pages 635-654, December.

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