Credit Derivative Pricing with Stochastic Volatility Models
AbstractThis paper proposes a framework for pricing credit derivatives within the defaultable Markovian HJM framework featuring unspanned stochastic volatility. Motivated by empirical evidence, hump-shaped level dependent stochastic volatility specifications are proposed, such that the model admits finite dimensional Markovian structures. The model also accommodates a correlation structure between the stochastic volatility, default-free interest rates and credit spreads. Default free and defaultable bonds are explicitly priced and an approach for pricing credit default swaps and swaptions is presented where the credit swap rates can be approximated by defaultable bond prices with varying maturities. A sensitivity analysis capturing the impact of the model parameters including correlations and stochastic volatility, on the credit swap rate and the value of the credit swaption is also presented.
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Bibliographic InfoPaper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 293.
Date of creation: 01 Jul 2011
Date of revision:
stochastic volatility; Heath-Jarrow-Morton framework; defaultable bond prices; credit spreads; CDS rates;
Other versions of this item:
- Carl Chiarella & Samuel Chege Maina & Christina Nikitopoulos Sklibosios, 2013. "Credit Derivatives Pricing With Stochastic Volatility Models," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 16(04), pages 1350019-1-1.
- NEP-ALL-2011-11-14 (All new papers)
- NEP-BAN-2011-11-14 (Banking)
- NEP-FMK-2011-11-14 (Financial Markets)
- NEP-ORE-2011-11-14 (Operations Research)
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