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A general firm value model under partial information

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  • Mbaye, Cheikh

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

  • Sagna, Abass
  • Vrins, Frédéric

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

Abstract

We introduce a new structural default model which purpose is to combine enhanced economic relevance and affordable computational complexity. Our approach exploits the information conveyed by a noisy observation of the firm value combined with the firm’s actual default state. Moreover, it is rather general since any diffusion can be used to depict the firm’s dynamics. However, this realistic setup comes at the expense of important computational challenges. To mitigate them, we propose an implementation based on recursive quantization. A thorough analysis of the approximation error resulting from our numerical procedure is provided. The power of our method is illustrated on the pricing of CDS options. This analysis reveals that the observation noise has a significant impact on the credit spreads’ implied volatility.

Suggested Citation

  • Mbaye, Cheikh & Sagna, Abass & Vrins, Frédéric, 2022. "A general firm value model under partial information," LIDAM Discussion Papers LFIN 2022009, Université catholique de Louvain, Louvain Finance (LFIN).
    • Handle: RePEc:ajf:louvlf:2022009
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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. Laura Ballotta & Gianluca Fusai, 2015. "Counterparty credit risk in a multivariate structural model with jumps," Finance, Presses universitaires de Grenoble, vol. 36(1), pages 39-74.
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    Keywords

    Finance ; credit risk ; structural model ; noisy information ; non-linear filtering;
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