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A general firm-value model under partial information

Author

Listed:
  • Mbaye, Cheikh

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

  • Sagna, Abass
  • Vrins, Frédéric

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

Abstract

We introduce a new structural default model which purpose is to combine enhanced economic relevance and affordable computational complexity. Our approach exploits the information conveyed by a noisy observation of the firm value combined with the firm’s actual default state. Moreover, it is rather general since any diffusion can be used to depict the firm’s dynamics. However, this realistic setup comes at the expense of important computational challenges. To mitigate them, we propose an implementation based on recursive quantization. A thorough analysis of the approximation error resulting from our numerical procedure is provided. The power of our method is illustrated on the pricing of CDS options. This analysis reveals that the observation noise has a significant impact on the credit spreads’ implied volatility.

Suggested Citation

  • Mbaye, Cheikh & Sagna, Abass & Vrins, Frédéric, 2022. "A general firm-value model under partial information," LIDAM Reprints LFIN 2022008, Université catholique de Louvain, Louvain Finance (LFIN).
    • Handle: RePEc:ajf:louvlr:2022008
    Note: In: Journal of Computational Finance, 2022
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    References listed on IDEAS

    as
    1. Delia Coculescu & Hélyette Geman & Monique Jeanblanc, 2008. "Valuation of default-sensitive claims under imperfect information," Finance and Stochastics, Springer, vol. 12(2), pages 195-218, April.
    2. R. J. Elliott & M. Jeanblanc & M. Yor, 2000. "On Models of Default Risk," Mathematical Finance, Wiley Blackwell, vol. 10(2), pages 179-195, April.
    3. Rüdiger Frey & Lars Rösler & Dan Lu, 2019. "Corporate security prices in structural credit risk models with incomplete information," Mathematical Finance, Wiley Blackwell, vol. 29(1), pages 84-116, January.
    4. Nan Chen & S. G. Kou, 2009. "Credit Spreads, Optimal Capital Structure, And Implied Volatility With Endogenous Default And Jump Risk," Mathematical Finance, Wiley Blackwell, vol. 19(3), pages 343-378, July.
    5. Duffie, Darrell & Lando, David, 2001. "Term Structures of Credit Spreads with Incomplete Accounting Information," Econometrica, Econometric Society, vol. 69(3), pages 633-664, May.
    6. Laura Ballotta & Gianluca Fusai, 2015. "Counterparty credit risk in a multivariate structural model with jumps," Finance, Presses universitaires de Grenoble, vol. 36(1), pages 39-74.
    7. Ballotta, Laura & Fusai, Gianluca & Marazzina, Daniele, 2019. "Integrated structural approach to Credit Value Adjustment," European Journal of Operational Research, Elsevier, vol. 272(3), pages 1143-1157.
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