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A reduced‐form model for pricing defaultable bonds and credit default swaps with stochastic recovery
Author(s) -
Pan Jian,
Xiao Qingxian
Publication year - 2016
Publication title -
applied stochastic models in business and industry
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.413
H-Index - 40
eISSN - 1526-4025
pISSN - 1524-1904
DOI - 10.1002/asmb.2200
Subject(s) - credit default swap , bond , credit derivative , swap (finance) , credit risk , stochastic differential equation , portfolio , econometrics , economics , computer science , actuarial science , mathematics , financial economics , finance
This paper presents a reduced‐form model for pricing defaultable bonds and credit default swaps (CDSs) with stochastic recovery, where the recovery risk is coupled with the default intensity, while the default intensity is described by a stochastic differential equation. Closed‐form pricing formulae for defaultable bonds and CDSs are obtained by applying variable change techniques and partial differential equation approaches. The closed‐form pricing formulae can provide valuable assistance in analyzing certain complications associated with portfolio management and hedging analysis. Finally, numerical experiments are provided to illustrate how the recovery parameters and intensity parameters affect the credit spread of a defaultable bond and the swap premium of a CDS. Copyright © 2016 John Wiley & Sons, Ltd.