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Flexing the default barrier

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  • Gregor Dorfleitner
  • Paul Schneider
  • Tanja Veža

Abstract

The paper introduces a Black–Cox-type structural model for credit default swaps (CDS). The existing literature on structural CDS pricing is extended by allowing a general functional form for the default barrier specified without reference to asset volatilities, dividend yields or interest rates. We develop a fast and robust algorithm to compute survival probabilities numerically. An empirical application suggests that the market-implied barrier is stable over time, with a possibly hump-shaped term structure. The implied barrier can be used for computing survival probabilities consistent with objective expectations of asset evolution, for pricing under counterparty risk, and for determining optimal corporate bond covenants.

Suggested Citation

  • Gregor Dorfleitner & Paul Schneider & Tanja Veža, 2011. "Flexing the default barrier," Quantitative Finance, Taylor & Francis Journals, vol. 11(12), pages 1729-1743.
    • Handle: RePEc:taf:quantf:v:11:y:2011:i:12:p:1729-1743
    DOI: 10.1080/14697688.2010.481633
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    Cited by:

    1. Bougias, Alexandros & Episcopos, Athanasios & Leledakis, George N., 2022. "The role of asset payouts in the estimation of default barriers," International Review of Financial Analysis, Elsevier, vol. 81(C).
    2. Feldhütter, Peter & Schaefer, Stephen, 2023. "Debt dynamics and credit risk," Journal of Financial Economics, Elsevier, vol. 149(3), pages 497-535.

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