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A Two Factor Black-Karasinski Credit Default Swap Pricing Model (forthcoming in the Icfai Journal of Derivatives Markets, Vol IV, No 4, October 2007; all copyrights rest with the Icfai University Press)

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  • Marco Realdon

Abstract

This paper presents, estimates and tests a reduced form sovereign credit default swap (CDS) pricing model where the default intensity is driven by two latent Black-Karasinski-type processes. CDS pricing re- quires finite difference numerical solutions, but parameter estimation is still feasible. Evidence from a sample of sovereign CDS rates shows the good empirical performance of the model and that a second stochastic factor driving the default intensity is statistically significant. Surprisingly the evidence fails to support the view that the risk associated with the dynamics of the default intensity is priced. For all countries the bulk of variations of the default intensity are explained by just one factor. As a by-product, a viable methodology for maximum likelihood estimation of pricing models with two latent factors is provided despite the fact that the pricing requires numerical solutions through finite difference methods.

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Bibliographic Info

Paper provided by Department of Economics, University of York in its series Discussion Papers with number 07/25.

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Date of creation: Sep 2007
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Handle: RePEc:yor:yorken:07/25

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Postal: Department of Economics and Related Studies, University of York, York, YO10 5DD, United Kingdom
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Keywords: sovereign CDS pricing; reduced-form credit risk model; Black-Karasinski; implicit .nite di¤erence method; maximum likelihood estimation.;

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  1. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
  2. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
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  7. Langetieg, Terence C, 1980. " A Multivariate Model of the Term Structure," Journal of Finance, American Finance Association, vol. 35(1), pages 71-97, March.
  8. Qiang Dai & Kenneth Singleton, 2003. "Term Structure Dynamics in Theory and Reality," Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 631-678, July.
  9. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  10. Li Chen & Damir Filipović & H. Vincent Poor, 2004. "Quadratic Term Structure Models For Risk-Free And Defaultable Rates," Mathematical Finance, Wiley Blackwell, vol. 14(4), pages 515-536.
  11. Juan Ignacio Pena & Santiago Forte, 2006. "CREDIT SPREADS: THEORY AND EVIDENCE ABOUT THE INFORMATION CONTENT OF STOCKS, BONDS AND CDSs," Business Economics Working Papers wb063310, Universidad Carlos III, Departamento de Economía de la Empresa.
  12. Chen, Ren-Raw & Cheng, Xiaolin & Fabozzi, Frank J. & Liu, Bo, 2008. "An Explicit, Multi-Factor Credit Default Swap Pricing Model with Correlated Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(01), pages 123-160, March.
  13. Dong-Hyun Ahn & Robert F. Dittmar, 2002. "Quadratic Term Structure Models: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 243-288, March.
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