Flexing the Default Barrier

33 Pages Posted: 16 Feb 2009

See all articles by Gregor Dorfleitner

Gregor Dorfleitner

University of Regensburg - Department of Finance

Paul Schneider

University of Lugano - Institute of Finance; Swiss Finance Institute

Tanja Veza

WU Vienna (Vienna University of Economics and Business)

Date Written: December 18, 2008

Abstract

The paper introduces a Black\&Cox-type structural model for credit default swaps. The existing literature on structural CDS pricing is extended by allowing a general functional form for the default barrier specified without reference to asset volatilities, dividend yields and interest rates. We develop a fast and robust algorithm to compute survival probabilities numerically. An empirical application suggests that the market-implied barrier is stable over time, with a possibly hump-shaped term structure. The implied barrier can be used for computing survival probabilities consistent with objective expectations of asset evolution, for pricing under counterparty risk, and for determining optimal corporate bond covenants.

Keywords: credit default swap, structural model, default boundary, the Green function, calibration

JEL Classification: C13, G12, G13, G15

Suggested Citation

Dorfleitner, Gregor and Schneider, Paul Georg and Veza, Tanja, Flexing the Default Barrier (December 18, 2008). Available at SSRN: https://ssrn.com/abstract=1343513 or http://dx.doi.org/10.2139/ssrn.1343513

Gregor Dorfleitner

University of Regensburg - Department of Finance ( email )

Regensburg, 93040
Germany

Paul Georg Schneider

University of Lugano - Institute of Finance ( email )

Via Buffi 13
CH-6900 Lugano
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Tanja Veza (Contact Author)

WU Vienna (Vienna University of Economics and Business) ( email )

Institute for Banking and Finance
Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria

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