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Credit Derivatives Pricing with a Smile-Extended Jump Stochastic Intensity Model

Author

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  • Damiano Brigo
  • Naoufel El-Bachir

    (ICMA Centre, University of Reading)

Abstract

We present a two-factor stochastic default intensity and interest rate model for pricing single-name default swaptions. The specific positive square root processes considered fall in the relatively tractable class of affine jump diffusions while allowing for inclusion of stochastic volatility and jumps in default swap spreads. The parameters of the short rate dynamics are first calibrated to the interest rates markets, before calibrating separately the default intensity model to credit derivatives market data. A few variants of the model are calibrated in turn to market data, and different calibration procedures are compared. Numerical experiments show that the calibrated model can generate plausible volatility smiles. Hence, the model can be calibrated to a default swap term structure and few default swaptions, and the calibrated parameters can be used to value consistently other default swaptions (different strikes and maturities, or more complex structures) on the same credit reference name.

Suggested Citation

  • Damiano Brigo & Naoufel El-Bachir, 2006. "Credit Derivatives Pricing with a Smile-Extended Jump Stochastic Intensity Model," ICMA Centre Discussion Papers in Finance icma-dp2006-13, Henley Business School, University of Reading.
  • Handle: RePEc:rdg:icmadp:icma-dp2006-13
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    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2006-13.pdf
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    References listed on IDEAS

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    1. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
    2. Remigijus Mikulevicius & Eckhard Platen, 1988. "Time Discrete Taylor Approximations for Ito Processes with Jump Component," Published Paper Series 1988-1, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
    3. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    4. Alfonsi Aurélien, 2005. "On the discretization schemes for the CIR (and Bessel squared) processes," Monte Carlo Methods and Applications, De Gruyter, vol. 11(4), pages 355-384, December.
    5. Farshid Jamshidian, 2004. "Valuation of credit default swaps and swaptions," Finance and Stochastics, Springer, vol. 8(3), pages 343-371, August.
    6. Damiano Brigo & Aurélien Alfonsi, 2005. "Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model," Finance and Stochastics, Springer, vol. 9(1), pages 29-42, January.
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    Cited by:

    1. Damiano Brigo & Naoufel El-Bachir, 2007. "An exact formula for default swaptions' pricing in the SSRJD stochastic intensity model," ICMA Centre Discussion Papers in Finance icma-dp2007-14, Henley Business School, University of Reading.
    2. Jang, Jiwook & Mohd Ramli, Siti Norafidah, 2015. "Jump diffusion transition intensities in life insurance and disability annuity," Insurance: Mathematics and Economics, Elsevier, vol. 64(C), pages 440-451.

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    More about this item

    Keywords

    Credit derivatives; credit default; swap; credit default swaption; jump-diffusion; stochastic intensity; doubly stochastic poisson process; cox process;
    All these keywords.

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C65 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Miscellaneous Mathematical Tools
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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