Local Volatility Enhanced by a Jump to Default
17 Pages Posted: 28 Jan 2010 Last revised: 13 May 2010
Date Written: January 22, 2010
A local volatility model is enhanced by the possibility of a single jump to default. The jump has a hazard rate that is the product of the stock price raised to a prespecified negative power and a deterministic function of time. The empirical work uses a power of -1.5. It is shown how one may simultaneously recover from the prices of credit default swap contracts and equity option prices both the deterministic component of the hazard rate function and revised local volatility. The procedure is implemented on prices of credit default swaps and equity options for GM and FORD over the period October 2004 to September 2007.
Keywords: Hazard Rates, CDS Curves, Weibull Distribution, VGSSD Sato Process
JEL Classification: G1, G12, G13
Suggested Citation: Suggested Citation