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A factor model for joint default probabilities. Pricing of CDS, index swaps and index tranches

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journal contribution
posted on 2023-06-09, 20:22 authored by Catalin Cantia, Radu TunaruRadu Tunaru
A factor model is proposed for the valuation of credit default swaps, credit indices and CDO contracts. The model of default is based on the first-passage distribution of a Brownian motion time modified by a continuous time-change. Various model specifications fall under this general approach based on defining the credit-quality process as an innovative time-change of a standard Brownian motion where the volatility process is mean reverting Lévy driven OU type process. Our models are bottom-up and can account for sudden moves in the level of CDS spreads representing the so-called credit gap risk. We develop FFT computational tools for calculating the distribution of losses and we show how to apply them to several specifications of the time-changed Brownian motion. Our line of modelling is flexible enough to facilitate the derivation of analytical formulae for conditional probabilities of default and prices of credit derivatives.

History

Publication status

  • Published

File Version

  • Accepted version

Journal

Insurance: Mathematics and Economics

ISSN

0167-6687

Publisher

Elsevier

Volume

72

Page range

21-35

Department affiliated with

  • Accounting and Finance Publications

Research groups affiliated with

  • Quantitative International Finance Network Publications

Full text available

  • Yes

Peer reviewed?

  • Yes

Legacy Posted Date

2020-01-23

First Open Access (FOA) Date

2020-01-31

First Compliant Deposit (FCD) Date

2020-01-31

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