American Step-Up and Step-Down Credit Default Swaps Under Levy Models
Osaka University - Center for the Study of Finance and Insurance
December 25, 2010
Quantitative Finance, 2012, Forthcoming
This paper studies the valuation of a class of default swaps with the embedded option to switch to a different premium and notional principal anytime prior to a credit event. These are early exercisable contracts that give the protection buyer or seller the right to step-up, step-down, or cancel the swap position. The pricing problem is formulated under a structural credit risk model based on Levy processes. This leads to the analytic and numerical studies of several optimal stopping problems subject to early termination due to default. In a general spectrally negative Levy model, we rigorously derive the optimal exercise strategy. This allows for instant computation of the credit spread under various specifications. Numerical examples are provided to examine the impacts of default risk and contractual features on the credit spread and exercise strategy.
Number of Pages in PDF File: 36
Keywords: Optimal Stopping, Credit Default Swaps, Step-Up and Step-Down Options, Levy Processes, Scale Functions
JEL Classification: G13, G33, D81, C61Accepted Paper Series
Date posted: December 26, 2010 ; Last revised: October 1, 2012
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