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Stochastic Volatility Effects on Defaultable Bonds

Author

Listed:
  • Jean-Pierre Fouque
  • Ronnie Sircar
  • Knut Sølna

Abstract

This paper studies the effect of introducing stochastic volatility in the first-passage structural approach to default risk. The impact of volatility time scales on the yield spread curve is analyzed. In particular it is shown that the presence of a short time scale in the volatility raises the yield spreads at short maturities. It is argued that combining first passage default modelling with multiscale stochastic volatility produces more realistic yield spreads. Moreover, this framework enables the use of perturbation techniques to derive explicit approximations which facilitate the complicated issue of calibration of parameters.

Suggested Citation

  • Jean-Pierre Fouque & Ronnie Sircar & Knut Sølna, 2006. "Stochastic Volatility Effects on Defaultable Bonds," Applied Mathematical Finance, Taylor & Francis Journals, vol. 13(3), pages 215-244.
  • Handle: RePEc:taf:apmtfi:v:13:y:2006:i:3:p:215-244 DOI: 10.1080/13504860600563127
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    References listed on IDEAS

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    1. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-664, May.
    2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
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    Cited by:

    1. Michael B. Gordy & SØren Willemann, 2012. "Constant Proportion Debt Obligations: A Postmortem Analysis of Rating Models," Management Science, INFORMS, pages 476-492.
    2. Andreou, Elena & Ghysels, Eric, 2008. "Quality control for structural credit risk models," Journal of Econometrics, Elsevier, vol. 146(2), pages 364-375, October.
    3. Michael B. Gordy & SØren Willemann, 2012. "Constant Proportion Debt Obligations: A Postmortem Analysis of Rating Models," Management Science, INFORMS, pages 476-492.
    4. Masaaki Fukasawa, 2011. "Asymptotic analysis for stochastic volatility: martingale expansion," Finance and Stochastics, Springer, vol. 15(4), pages 635-654, December.
    5. Samuel Chege Maina, 2011. "Credit Risk Modelling in Markovian HJM Term Structure Class of Models with Stochastic Volatility," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 5.

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