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An intensity model for credit risk with switching L�vy processes

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  • Donatien Hainaut
  • Olivier Le Courtois

Abstract

We develop a switching regime version of the intensity model for credit risk pricing. The default event is specified by a Poisson process whose intensity is modeled by a switching L�vy process. This model presents several interesting features. First, as L�vy processes encompass numerous jump processes, our model can duplicate the sudden jumps observed in credit spreads. Also, due to the presence of jumps, probabilities do not vanish at very short maturities, contrary to models based on Brownian dynamics. Furthermore, as the parameters of the L�vy process are modulated by a hidden Markov chain, our approach is well suited to model changes of volatility trends in credit spreads, related to modifications of unobservable economic factors.

Suggested Citation

  • Donatien Hainaut & Olivier Le Courtois, 2012. "An intensity model for credit risk with switching L�vy processes," Quantitative Finance, Taylor & Francis Journals, vol. 14(8), pages 1453-1465, November.
    • Handle: RePEc:taf:quantf:v:14:y:2012:i:8:p:1453-1465
    DOI: 10.1080/14697688.2012.756583
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