Pricing Equity Default Swaps under the Jump to Default Extended CEV Model

23 Pages Posted: 18 May 2009 Last revised: 24 Jul 2014

See all articles by Vadim Linetsky

Vadim Linetsky

Northwestern University - Department of Industrial Engineering and Management Sciences

Rafael Mendoza-Arriaga

University of Texas at Austin - Department of Information, Risk and Operations Management

Date Written: July 1, 2011

Abstract

Equity default swaps (EDS) are hybrid credit-equity products that provide a bridge from credit default swaps (CDS) to equity derivatives with barriers. This paper develops an analytical solution to the EDS pricing problem under the Jump-to-Default Extended Constant Elasticity Variance Model (JDCEV) of Carr and Linetsky. Mathematically, we obtain an analytical solution to the first passage time problem for the JDCEV diffusion process with killing (jump to default). In particular, we obtain analytical results for the present values of the protection payoff at the triggering event, periodic premium payments up to the triggering event, and the interest accrued from the previous periodic premium payment up to the triggering event, and determine arbitrage-free equity default swap rates and compare them with corresponding CDS rates.

Suggested Citation

Linetsky, Vadim and Mendoza-Arriaga, Rafael, Pricing Equity Default Swaps under the Jump to Default Extended CEV Model (July 1, 2011). Finance Stochastics, Vol. 15, No. 3, 513-540, Available at SSRN: https://ssrn.com/abstract=1403545 or http://dx.doi.org/10.2139/ssrn.1403545

Vadim Linetsky

Northwestern University - Department of Industrial Engineering and Management Sciences ( email )

Evanston, IL 60208-3119
United States

Rafael Mendoza-Arriaga (Contact Author)

University of Texas at Austin - Department of Information, Risk and Operations Management ( email )

CBA 5.202
Austin, TX 78712
United States
5126321860 (Phone)

HOME PAGE: http://rafaelmendoza.org

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