A Two Factor Black-Karasinski Credit Default Swap Pricing Model (forthcoming in the Icfai Journal of Derivatives Markets, Vol IV, No 4, October 2007; all copyrights rest with the Icfai University Press)
This paper presents, estimates and tests a reduced form sovereign credit default swap (CDS) pricing model where the default intensity is driven by two latent Black-Karasinski-type processes. CDS pricing re- quires finite difference numerical solutions, but parameter estimation is still feasible. Evidence from a sample of sovereign CDS rates shows the good empirical performance of the model and that a second stochastic factor driving the default intensity is statistically significant. Surprisingly the evidence fails to support the view that the risk associated with the dynamics of the default intensity is priced. For all countries the bulk of variations of the default intensity are explained by just one factor. As a by-product, a viable methodology for maximum likelihood estimation of pricing models with two latent factors is provided despite the fact that the pricing requires numerical solutions through finite difference methods.
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