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Pricing transition risk with a jump-diffusion credit risk model: evidences from the CDS market

Author

Listed:
  • Livieri, Giulia
  • Radi, Davide
  • Smaniotto, Elia

Abstract

Transition risk can be defined as the business-risk related to the enactment of green policies, aimed at driving the society towards a sustainable and low-carbon economy. In particular, when new green laws are released, companies are forced to comply with the new standards, incurring in costs which can undermine their financial stability. In this paper we derive formulas for the pricing of defaultable coupon bonds and Credit Default Swaps to empirically demonstrate that a jump-diffusion credit risk model in which the downward jumps in the firm value are due to tighter green laws can capture, at least partially, the transition risk. The empirical investigation consists in the model calibration on the CDS term-structure, performing a quantile regression to assess the relationship between implied prices and a proxy of the transition risk. Additionally, we show that a model without jumps lacks this property, confirming the jump-like nature of the transition risk.

Suggested Citation

  • Livieri, Giulia & Radi, Davide & Smaniotto, Elia, 2024. "Pricing transition risk with a jump-diffusion credit risk model: evidences from the CDS market," LSE Research Online Documents on Economics 123650, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:123650
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    File URL: http://eprints.lse.ac.uk/123650/
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    More about this item

    Keywords

    derivatives; climate change; hypothesis testing; panel data; asset pricing; CDS spreads; credit risk; sustainable finance; transition risk;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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