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Default Swap Games Driven by Spectrally Negative Levy Processes

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  • Masahiko Egami
  • Tim S. T. Leung
  • Kazutoshi Yamazaki

Abstract

This paper studies game-type credit default swaps that allow the protection buyer and seller to raise or reduce their respective positions once prior to default. This leads to the study of an optimal stopping game subject to early default termination. Under a structural credit risk model based on spectrally negative Levy processes, we apply the principles of smooth and continuous fit to identify the equilibrium exercise strategies for the buyer and the seller. We then rigorously prove the existence of the Nash equilibrium and compute the contract value at equilibrium. Numerical examples are provided to illustrate the impacts of default risk and other contractual features on the players' exercise timing at equilibrium.

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File URL: http://arxiv.org/pdf/1105.0238
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Paper provided by arXiv.org in its series Papers with number 1105.0238.

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Date of creation: May 2011
Date of revision: Sep 2012
Publication status: Published in Stochastic Processes and their Applications Volume 123, Issue 2, 2013, Pages 347--384
Handle: RePEc:arx:papers:1105.0238

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  3. Florin Avram & Zbigniew Palmowski & Martijn R. Pistorius, 2007. "On the optimal dividend problem for a spectrally negative L\'{e}vy process," Papers math/0702893, arXiv.org.
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  7. Tim Siu-Tang Leung & Kazutoshi Yamazaki, 2010. "American Step-Up and Step-Down Default Swaps under Levy Models," Papers 1012.3234, arXiv.org, revised Sep 2012.
  8. Dilip B. Madan & Frank Milne, 1991. "Option Pricing With V. G. Martingale Components," Mathematical Finance, Wiley Blackwell, vol. 1(4), pages 39-55.
  9. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-67, May.
  10. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, vol. 6(2), pages 237-263.
  11. Andreas Kyprianou, 2004. "Some calculations for Israeli options," Finance and Stochastics, Springer, vol. 8(1), pages 73-86, January.
  12. Tomasz Bielecki & Stephane Crepey & Monique Jeanblanc & Marek Rutkowski, 2008. "Arbitrage pricing of defaultable game options with applications to convertible bonds," Quantitative Finance, Taylor & Francis Journals, vol. 8(8), pages 795-810.
  13. Biffis, Enrico & Kyprianou, Andreas E., 2010. "A note on scale functions and the time value of ruin for Lévy insurance risk processes," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 85-91, February.
  14. Baurdoux, E.J. & Kyprianou, A.E. & Pardo, J.C., 2011. "The Gapeev-Kühn stochastic game driven by a spectrally positive Lévy process," Stochastic Processes and their Applications, Elsevier, vol. 121(6), pages 1266-1289, June.
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