A jump to default extended CEV model: An application of Bessel processes

Peter Carr, Vadim Linetsky

Research output: Contribution to journalArticle

Abstract

We develop a flexible and analytically tractable framework which unifies the valuation of corporate liabilities, credit derivatives, and equity derivatives. We assume that the stock price follows a diffusion, punctuated by a possible jump to zero (default). To capture the positive link between default and equity volatility, we assume that the hazard rate of default is an increasing affine function of the instantaneous variance of returns on the underlying stock. To capture the negative link between volatility and stock price, we assume a constant elasticity of variance (CEV) specification for the instantaneous stock volatility prior to default. We show that deterministic changes of time and scale reduce our stock price process to a standard Bessel process with killing. This reduction permits the development of completely explicit closed form solutions for risk-neutral survival probabilities, CDS spreads, corporate bond values, and European-style equity options. Furthermore, our valuation model is sufficiently flexible so that it can be calibrated to exactly match arbitrarily given term structures of CDS spreads, interest rates, dividend yields, and at-the-money implied volatilities.

Original languageEnglish (US)
Pages (from-to)303-330
Number of pages28
JournalFinance and Stochastics
Volume10
Issue number3
DOIs
StatePublished - Sep 2006

Fingerprint

Bessel Process
Elasticity
Stock Prices
Equity
Jump
Volatility
Valuation
Instantaneous
Implied Volatility
Derivative
Term Structure
Affine Function
Dividend
Hazard Rate
Survival Probability
Increasing Functions
Interest Rates
Closed-form Solution
Model
Specification

Keywords

  • Bessel processes
  • CEV model
  • Corporate bonds
  • Credit derivatives
  • Credit spread
  • Default
  • Equity derivatives
  • Implied volatility skew

ASJC Scopus subject areas

  • Statistics and Probability
  • Finance
  • Statistics, Probability and Uncertainty

Cite this

A jump to default extended CEV model : An application of Bessel processes. / Carr, Peter; Linetsky, Vadim.

In: Finance and Stochastics, Vol. 10, No. 3, 09.2006, p. 303-330.

Research output: Contribution to journalArticle

Carr, Peter ; Linetsky, Vadim. / A jump to default extended CEV model : An application of Bessel processes. In: Finance and Stochastics. 2006 ; Vol. 10, No. 3. pp. 303-330.
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