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Risk Premia and Optimal Liquidation of Credit Derivatives

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  • Tim Leung
  • Peng Liu

Abstract

This paper studies the optimal timing to liquidate credit derivatives in a general intensity-based credit risk model under stochastic interest rate. We incorporate the potential price discrepancy between the market and investors, which is characterized by risk-neutral valuation under different default risk premia specifications. We quantify the value of optimally timing to sell through the concept of delayed liquidation premium, and analyze the associated probabilistic representation and variational inequality. We illustrate the optimal liquidation policy for both single-named and multi-named credit derivatives. Our model is extended to study the sequential buying and selling problem with and without short-sale constraint.

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  • Tim Leung & Peng Liu, 2011. "Risk Premia and Optimal Liquidation of Credit Derivatives," Papers 1110.0220, arXiv.org, revised Oct 2012.
  • Handle: RePEc:arx:papers:1110.0220
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    References listed on IDEAS

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    1. Alexander Schied & Torsten Schöneborn, 2009. "Risk aversion and the dynamics of optimal liquidation strategies in illiquid markets," Finance and Stochastics, Springer, vol. 13(2), pages 181-204, April.
    2. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson, "undated". "Measuring Default Risk Premia from Default Swap Rates and EDFs," GSIA Working Papers 2006-E31, Carnegie Mellon University, Tepper School of Business.
    3. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409 World Scientific Publishing Co. Pte. Ltd..
    4. Marco Frittelli, 2000. "The Minimal Entropy Martingale Measure and the Valuation Problem in Incomplete Markets," Mathematical Finance, Wiley Blackwell, vol. 10(1), pages 39-52.
    5. Robert A. Jarrow & David Lando & Fan Yu, 2008. "Default Risk And Diversification: Theory And Empirical Implications," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 19, pages 455-480 World Scientific Publishing Co. Pte. Ltd..
    6. Tim Leung & Michael Ludkovski, 2010. "Optimal Timing to Purchase Options," Papers 1008.3650, arXiv.org, revised Apr 2011.
    7. Robert Almgren, 2003. "Optimal execution with nonlinear impact functions and trading-enhanced risk," Applied Mathematical Finance, Taylor & Francis Journals, vol. 10(1), pages 1-18.
    8. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
    9. Azizpour, Shahriar & Giesecke, Kay & Kim, Baeho, 2011. "Premia for correlated default risk," Journal of Economic Dynamics and Control, Elsevier, vol. 35(8), pages 1340-1357, August.
    10. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    11. E. Bayraktar, 2008. "Pricing Options on Defaultable Stocks," Applied Mathematical Finance, Taylor & Francis Journals, vol. 15(3), pages 277-304.
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    Cited by:

    1. repec:wsi:jfexxx:v:02:y:2015:i:01:n:s234576861550004x is not listed on IDEAS
    2. Tim Leung & Jiao Li & Xin Li & Zheng Wang, 2016. "Speculative Futures Trading under Mean Reversion," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 23(4), pages 281-304, December.
    3. Jiao Li, 2016. "Trading VIX futures under mean reversion with regime switching," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 1-20, September.
    4. Tim Leung & Jiao Li & Xin Li, 2017. "Optimal Timing to Trade Along a Randomized Brownian Bridge," Papers 1801.00372, arXiv.org.
    5. Jiao Li, 2016. "Trading VIX Futures under Mean Reversion with Regime Switching," Papers 1605.07945, arXiv.org, revised Jun 2016.
    6. Brian Bulthuis & Julio Concha & Tim Leung & Brian Ward, 2017. "Optimal execution of limit and market orders with trade director, speed limiter, and fill uncertainty," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 4(02n03), pages 1-29, June.
    7. repec:wsi:ijtafx:v:18:y:2015:i:03:n:s021902491550020x is not listed on IDEAS
    8. Kim, Jinbeom & Leung, Tim, 2016. "Pricing derivatives with counterparty risk and collateralization: A fixed point approach," European Journal of Operational Research, Elsevier, vol. 249(2), pages 525-539.
    9. Tim Leung & Yoshihiro Shirai, 2015. "Optimal derivative liquidation timing under path-dependent risk penalties," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(01), pages 1-32.
    10. Tim Leung & Xin Li & Zheng Wang, 2015. "Optimal Multiple Trading Times Under the Exponential OU Model with Transaction Costs," Papers 1504.04682, arXiv.org.
    11. Tim Leung & Xin Li, 2015. "Optimal Mean Reversion Trading With Transaction Costs And Stop-Loss Exit," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-31.
    12. Tim Leung & Xin Li & Zheng Wang, 2014. "Optimal Starting-Stopping and Switching of a CIR Process with Fixed Costs," Papers 1411.6080, arXiv.org.

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