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Pricing Credit Default Swaps Under Multifactor Reduced-Form Models: A Differential Quadrature Approach

Author

Listed:
  • Alessandro Andreoli

    (Università Politecnica delle Marche)

  • Luca Vincenzo Ballestra

    (Seconda Università di Napoli)

  • Graziella Pacelli

    (Università Politecnica delle Marche)

Abstract

We present a new numerical method for pricing credit default swaps under fully correlated multifactor reduced-form models. In particular, the proposed approach combines an implicit/explicit operator splitting procedure with the harmonic differential quadrature scheme, and is so efficient that it can be applied to models with up to six stochastic factors. This is a remarkable advantage, as we can use two factors to describe the interest rate, other two factors to describe the default probability, and other two factors to take into account, for example, the so-called counterparty risk. The performances of the novel method are demonstrated by extensive simulation, in which various kinds of models with four and six fully correlated factors are considered.

Suggested Citation

  • Alessandro Andreoli & Luca Vincenzo Ballestra & Graziella Pacelli, 2018. "Pricing Credit Default Swaps Under Multifactor Reduced-Form Models: A Differential Quadrature Approach," Computational Economics, Springer;Society for Computational Economics, vol. 51(3), pages 379-406, March.
  • Handle: RePEc:kap:compec:v:51:y:2018:i:3:d:10.1007_s10614-016-9608-x
    DOI: 10.1007/s10614-016-9608-x
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    More about this item

    Keywords

    Credit default swap; CDS; Multifactor model; Operator splitting; Differential quadrature;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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