IDEAS home Printed from https://ideas.repec.org/a/kap/revdev/v21y2018i1d10.1007_s11147-017-9135-5.html
   My bibliography  Save this article

Tempered stable structural model in pricing credit spread and credit default swap

Author

Listed:
  • Sung Ik Kim

    (Stony Brook University)

  • Young Shin Kim

    (Stony Brook University)

Abstract

In this paper, we explore the features of a structural credit risk model wherein the firm value is driven by normal tempered stable (NTS) process belonging to the larger class of Lévy processes. For the purpose of comparability, the calibration to the term structure of a corporate bond credit spread is conducted under both NTS structural model and Merton structural model. We find that NTS structural model provides better fit for all credit ratings than Merton structural model. However, it is noticed that probabilities of default derived from the calibration of the term structure of a bond credit spread might be overestimated since the bond credit spread could contain non-default components such as illiquidity risk or asymmetric tax treatment. Hence, considering CDS spread as a reflection of the pure credit risk for the reference entity, we calibrate it in order to obtain more reasonable probability of default and obtain valid results in calibration of the market CDS spread with NTS structural model.

Suggested Citation

  • Sung Ik Kim & Young Shin Kim, 2018. "Tempered stable structural model in pricing credit spread and credit default swap," Review of Derivatives Research, Springer, vol. 21(1), pages 119-148, April.
    • Handle: RePEc:kap:revdev:v:21:y:2018:i:1:d:10.1007_s11147-017-9135-5
    DOI: 10.1007/s11147-017-9135-5
    as

    Download full text from publisher

    File URL: http://link.springer.com/10.1007/s11147-017-9135-5
    File Function: Abstract
    Download Restriction: Access to full text is restricted to subscribers.
    File URL: https://libkey.io/10.1007/s11147-017-9135-5?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Svetlana I. Boyarchenko & Sergei Z. Levendorskiǐ, 2000. "Option Pricing For Truncated Lévy Processes," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 3(03), pages 549-552.
    2. repec:bla:ecnote:v:33:y:2004:i:2:p:183-208 is not listed on IDEAS
    3. Fang, Fang & Oosterlee, Kees, 2008. "A Novel Pricing Method For European Options Based On Fourier-Cosine Series Expansions," MPRA Paper 9319, University Library of Munich, Germany.
    4. Leland, Hayne E & Toft, Klaus Bjerre, 1996. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    5. Delianedis, Gordon & Geske, Robert, 2001. "The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors," University of California at Los Angeles, Anderson Graduate School of Management qt32x284q3, Anderson Graduate School of Management, UCLA.
    6. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. "Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-625, July.
    7. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    8. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-367, May.
    9. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    10. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, vol. 6(2), pages 237-263.
    11. Young Kim & Frank Fabozzi & Zuodong Lin & Svetlozar Rachev, 2012. "Option pricing and hedging under a stochastic volatility Lévy process model," Review of Derivatives Research, Springer, vol. 15(1), pages 81-97, April.
    12. Pierre Collin‐Dufresne & Robert S. Goldstein, 2001. "Do Credit Spreads Reflect Stationary Leverage Ratios?," Journal of Finance, American Finance Association, vol. 56(5), pages 1929-1957, October.
    13. Neil Shephard & Ole E. Barndorff-Nielsen & University of Aarhus, 2001. "Normal Modified Stable Processes," Economics Series Working Papers 72, University of Oxford, Department of Economics.
    14. O.E. Barndorff-Nielsen & S.Z. Levendorskii, 2001. "Feller processes of normal inverse Gaussian type," Quantitative Finance, Taylor & Francis Journals, vol. 1(3), pages 318-331, March.
    15. Young Kim & Rosella Giacometti & Svetlozar Rachev & Frank Fabozzi & Domenico Mignacca, 2012. "Measuring financial risk and portfolio optimization with a non-Gaussian multivariate model," Annals of Operations Research, Springer, vol. 201(1), pages 325-343, December.
    16. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    17. Robert A. Jarrow & David Lando & Stuart M. Turnbull, 2008. "A Markov Model for the Term Structure of Credit Risk Spreads," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 18, pages 411-453, World Scientific Publishing Co. Pte. Ltd..
    18. Alan L. Lewis, 2001. "A Simple Option Formula for General Jump-Diffusion and other Exponential Levy Processes," Related articles explevy, Finance Press.
    19. Duffie, Darrell & Singleton, Kenneth J, 1997. "An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
    20. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
    21. Benoit Mandelbrot, 1963. "New Methods in Statistical Economics," Journal of Political Economy, University of Chicago Press, vol. 71(5), pages 421-421.
    22. Jing-Zhi Huang & Ming Huang, 2012. "How Much of the Corporate-Treasury Yield Spread Is Due to Credit Risk?," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 2(2), pages 153-202.
    23. Longstaff, Francis A & Schwartz, Eduardo S, 1995. "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    24. Peter Carr & Helyette Geman, 2002. "The Fine Structure of Asset Returns: An Empirical Investigation," The Journal of Business, University of Chicago Press, vol. 75(2), pages 305-332, April.
    25. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 541-552, November.
    26. Anand, Abhinav & Li, Tiantian & Kurosaki, Tetsuo & Kim, Young Shin, 2016. "Foster–Hart optimal portfolios," Journal of Banking & Finance, Elsevier, vol. 68(C), pages 117-130.
    27. Kim, Young Shin & Lee, Jaesung & Mittnik, Stefan & Park, Jiho, 2015. "Quanto option pricing in the presence of fat tails and asymmetric dependence," Journal of Econometrics, Elsevier, vol. 187(2), pages 512-520.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kim, Sung Ik, 2023. "A comparative study of firm value models: Default risk of corporate bonds," Finance Research Letters, Elsevier, vol. 56(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Kim, Sung Ik, 2023. "A comparative study of firm value models: Default risk of corporate bonds," Finance Research Letters, Elsevier, vol. 56(C).
    2. repec:wyi:journl:002109 is not listed on IDEAS
    3. Samuel Chege Maina, 2011. "Credit Risk Modelling in Markovian HJM Term Structure Class of Models with Stochastic Volatility," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1-2011, January-A.
    4. Samuel Chege Maina, 2011. "Credit Risk Modelling in Markovian HJM Term Structure Class of Models with Stochastic Volatility," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 5, July-Dece.
    5. Stephanie Heck, 2022. "Corporate bond yields and returns: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 36(2), pages 179-201, June.
    6. Murphy, Austin & Headley, Adrian, 2022. "An empirical evaluation of alternative fundamental models of credit spreads," International Review of Financial Analysis, Elsevier, vol. 81(C).
    7. Giesecke, Kay & Longstaff, Francis A. & Schaefer, Stephen & Strebulaev, Ilya, 2011. "Corporate bond default risk: A 150-year perspective," Journal of Financial Economics, Elsevier, vol. 102(2), pages 233-250.
    8. Goldstein, Michael A. & Namin, Elmira Shekari, 2023. "Corporate bond liquidity and yield spreads: A review," Research in International Business and Finance, Elsevier, vol. 65(C).
    9. Abel Elizalde, 2006. "Credit Risk Models II: Structural Models," Working Papers wp2006_0606, CEMFI.
    10. Duffie, Darrell, 2003. "Intertemporal asset pricing theory," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 11, pages 639-742, Elsevier.
    11. Jing-Zhi Huang & Zhan Shi & Hao Zhou, 2020. "Specification Analysis of Structural Credit Risk Models [Corporate bond valuation and hedging with stochastic interest rates and endogenous bankruptcy]," Review of Finance, European Finance Association, vol. 24(1), pages 45-98.
    12. Antonio Trujillo-Ponce & Reyes Samaniego-Medina & Clara Cardone-Riportella, 2014. "Examining what best explains corporate credit risk: accounting-based versus market-based models," Journal of Business Economics and Management, Taylor & Francis Journals, vol. 15(2), pages 253-276, April.
    13. Augustin, Patrick & Subrahmanyam, Marti G. & Tang, Dragon Yongjun & Wang, Sarah Qian, 2014. "Credit Default Swaps: A Survey," Foundations and Trends(R) in Finance, now publishers, vol. 9(1-2), pages 1-196, December.
    14. Specht, Leon, 2023. "An Empirical Analysis of European Credit Default Swap Spread Dynamics," Junior Management Science (JUMS), Junior Management Science e. V., vol. 8(1), pages 1-42.
    15. Stephen Zamore & Kwame Ohene Djan & Ilan Alon & Bersant Hobdari, 2018. "Credit Risk Research: Review and Agenda," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 54(4), pages 811-835, March.
    16. Tsung-Kang Chen & Hsien-Hsing Liao & Chia-Wu Lu, 2011. "A flow-based corporate credit model," Review of Quantitative Finance and Accounting, Springer, vol. 36(4), pages 517-532, May.
    17. Duffie, Darrell, 2005. "Credit risk modeling with affine processes," Journal of Banking & Finance, Elsevier, vol. 29(11), pages 2751-2802, November.
    18. International Association of Deposit Insurers, 2011. "Evaluation of Deposit Insurance Fund Sufficiency on the Basis of Risk Analysis," IADI Research Papers 11-11, International Association of Deposit Insurers.
    19. Martin Dòzsa & Karel Janda, 2015. "Corporate asset pricing models and debt contracts," CAMA Working Papers 2015-33, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    20. Lekkos, Ilias, 2007. "Modelling multiple term structures of defaultable bonds with common and idiosyncratic state variables," Journal of Empirical Finance, Elsevier, vol. 14(5), pages 783-817, December.
    21. Qiang Dai & Kenneth Singleton, 2003. "Term Structure Dynamics in Theory and Reality," The Review of Financial Studies, Society for Financial Studies, vol. 16(3), pages 631-678, July.

    More about this item

    Keywords

    Normal tempered stable process; Structural model; Credit risk; Credit derivatives;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:kap:revdev:v:21:y:2018:i:1:d:10.1007_s11147-017-9135-5. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Sonal Shukla or Springer Nature Abstracting and Indexing (email available below). General contact details of provider: http://www.springer.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.