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Assessing Credit with Equity: A CEV Model with Jump to Default

  • Luciano Campi

    ()

    (CEREMADE, Université Paris Dauphine)

  • Simon Polbennikov

    ()

    (Econometrics and Operations Research, Tilburg University, The Netherlands,)

  • Sbuelz

    ()

    (Department of Economics (University of Verona))

Registered author(s):

    Unlike in structural and reduced-form models, we use equity as a liquid and observable primitive to analytically value corporate bonds and credit default swaps. Restrictive assumptions on the firm’s capital structure are avoided. Default is parsimoniously represented by equity value hitting the zero barrier. Default can be either predictable, according to a CEV process that yields a positive probability of diffusive default and enables the leverage effect, or unpredictable, according to a Poisson-process jump that implies non-zero credit spreads for short maturities. Easy cross-asset hedging is enabled. By means of a carefully specified pricing kernel, we also enable analytical credit-risk management under possibly systematic jump-to-default risk.

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    File URL: http://dse.univr.it/RePEc/ver/Wpaper/WP24.pdf
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    Paper provided by University of Verona, Department of Economics in its series Working Papers with number 24.

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    Length: 40
    Date of creation: Sep 2005
    Date of revision:
    Handle: RePEc:ver:wpaper:24
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    1. Viral V. Acharya & Jennifer N. Carpenter, 2002. "Corporate Bond Valuation and Hedging with Stochastic Interest Rates and Endogenous Bankruptcy," Review of Financial Studies, Society for Financial Studies, vol. 15(5), pages 1355-1383.
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