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A reduced‐form model for pricing defaultable bonds and credit default swaps with stochastic recovery

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  • Jian Pan
  • Qingxian Xiao

Abstract

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.

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  • Jian Pan & Qingxian Xiao, 2016. "A reduced‐form model for pricing defaultable bonds and credit default swaps with stochastic recovery," Applied Stochastic Models in Business and Industry, John Wiley & Sons, vol. 32(5), pages 725-739, September.
    • Handle: RePEc:wly:apsmbi:v:32:y:2016:i:5:p:725-739
    DOI: 10.1002/asmb.2200
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    Cited by:

    1. Puneet Pasricha & Dharmaraja Selvamuthu & Selvaraju Natarajan, 2022. "A contagion process with self-exciting jumps in credit risk applications," Papers 2202.12946, arXiv.org.

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