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Assessing Credit with Equity: A CEV Model with Jump to Default

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Author Info

  • Luciano Campi

    ()
    (CEREMADE, Université Paris Dauphine)

  • Simon Polbennikov

    ()
    (Econometrics and Operations Research, Tilburg University, The Netherlands,)

  • Sbuelz

    ()
    (Department of Economics (University of Verona))

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    Abstract

    Unlike in structural and reduced-form models, we use equity as a liquid and observable primitive to analytically value corporate bonds and credit default swaps. Restrictive assumptions on the firm’s capital structure are avoided. Default is parsimoniously represented by equity value hitting the zero barrier. Default can be either predictable, according to a CEV process that yields a positive probability of diffusive default and enables the leverage effect, or unpredictable, according to a Poisson-process jump that implies non-zero credit spreads for short maturities. Easy cross-asset hedging is enabled. By means of a carefully specified pricing kernel, we also enable analytical credit-risk management under possibly systematic jump-to-default risk.

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    File URL: http://dse.univr.it/RePEc/ver/Wpaper/WP24.pdf
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    Bibliographic Info

    Paper provided by University of Verona, Department of Economics in its series Working Papers with number 24.

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    Length: 40
    Date of creation: Sep 2005
    Date of revision:
    Handle: RePEc:ver:wpaper:24

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    Related research

    Keywords: Equity; Corporate Bonds; Credit Default Swaps; Constant-Elasticity-of-Variance (CEV) Diffusion; Jump to Default;

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    References

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    1. Acharya, Viral V & Carpenter, Jennifer, 2002. "Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy," CEPR Discussion Papers 3328, C.E.P.R. Discussion Papers.
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    Cited by:
    1. Maclachlan, Iain C, 2007. "An empirical study of corporate bond pricing with unobserved capital structure dynamics," MPRA Paper 28416, University Library of Munich, Germany.

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