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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))
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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Publisher Info
Paper provided by Università di Verona, Dipartimento di Scienze economiche in its series Working Papers with number 24.

Download reference. The following formats are available: HTML (with abstract), plain text (with abstract), BibTeX, RIS (EndNote, RefMan, ProCite), ReDIF
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;

Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

This paper has been announced in the following NEP Reports:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  2. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-70, March. [Downloadable!] (restricted)
  3. Schroder, Mark Douglas, 1989. " Computing the Constant Elasticity of Variance Option Pricing Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 211-19, March. [Downloadable!] (restricted)
  4. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166. [Downloadable!] (restricted)
  5. Sbuelz, A. & Guha, R., 2003. "Structural rfv: recovery form and defaultable debt analysis," Discussion Paper 37, Tilburg University, Center for Economic Research. [Downloadable!]
  6. Emanuel, David C. & MacBeth, James D., 1982. "Further Results on the Constant Elasticity of Variance Call Option Pricing Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 17(04), pages 533-554, November. [Downloadable!]
  7. Rita L. D'Ecclesia & Robert G. Tompkins, 2005. "Estimating default probabilities using a non parametric approach," Computing in Economics and Finance 2005 116, Society for Computational Economics.
  8. 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. [Downloadable!] (restricted)
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    Other versions:
  10. Blanchet-Scalliet, Christophette & El Karoui, Nicole & Martellini, Lionel, 2005. "Dynamic asset pricing theory with uncertain time-horizon," Journal of Economic Dynamics and Control, Elsevier, vol. 29(10), pages 1737-1764, October. [Downloadable!] (restricted)
  11. Viral V. Acharya & Jennifer N. Carpenter, 2002. "Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 15(5), pages 1355-1383.
    Other versions:
  12. Goldenberg, David H., 1991. "A unified method for pricing options on diffusion processes," Journal of Financial Economics, Elsevier, vol. 29(1), pages 3-34, March. [Downloadable!] (restricted)
  13. Beckers, Stan, 1980. " The Constant Elasticity of Variance Model and Its Implications for Option Pricing," Journal of Finance, American Finance Association, vol. 35(3), pages 661-73, June. [Downloadable!] (restricted)
  14. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-64, May.
  15. Robert F. Engle & Gary G.J. Lee, 1993. "A Permanent and Transitory Component Model of Stock Return Volatility," University of California at San Diego, Economics Working Paper Series 92-44r, Department of Economics, UC San Diego. [Downloadable!]
  16. Chunsheng Zhou, 1997. "A jump-diffusion approach to modeling credit risk and valuing defaultable securities," Finance and Economics Discussion Series 1997-15, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  17. Cornell, Bradford & Green, Kevin, 1991. " The Investment Performance of Low-Grade Bond Funds," Journal of Finance, American Finance Association, vol. 46(1), pages 29-48, March. [Downloadable!] (restricted)
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