Credit Derivative Pricing with Stochastic Volatility Models

University of Technology Sydney Quantitative Finance Research Centre Research Paper No. 293

40 Pages Posted: 23 Oct 2012

See all articles by Carl Chiarella

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group

Samuel Chege Maina

University of Technology Sydney (UTS) - School of Finance and Economics

Christina Sklibosios Nikitopoulos

University of Technology Sydney - Business School; Financial Research Network (FIRN)

Date Written: July 1, 2011

Abstract

This paper proposes a framework for pricing credit derivatives within the defaultable Markovian HJM framework featuring unspanned stochastic volatility. Motivated by empirical evidence, hump-shaped level dependent stochastic volatility specifications are proposed, such that the model admits finite dimensional Markovian structures. The model also accommodates a correlation structure between the stochastic volatility, default-free interest rates and credit spreads. Default free and defaultable bonds are explicitly priced and an approach for pricing credit default swaps and swaptions is presented where the credit swap rates can be approximated by defaultable bond prices with varying maturities. A sensitivity analysis capturing the impact of the model parameters including correlations and stochastic volatility, on the credit swap rate and the value of the credit swaption is also presented.

Keywords: stochastic volatility, Heath-Jarrow-Morton framework, defaultable bond prices, credit spreads, CDS rates

Suggested Citation

Chiarella, Carl and Maina, Samuel Chege and Sklibosios Nikitopoulos, Christina, Credit Derivative Pricing with Stochastic Volatility Models (July 1, 2011). University of Technology Sydney Quantitative Finance Research Centre Research Paper No. 293, Available at SSRN: https://ssrn.com/abstract=2165638 or http://dx.doi.org/10.2139/ssrn.2165638

Carl Chiarella (Contact Author)

University of Technology, Sydney - UTS Business School, Finance Discipline Group ( email )

PO Box 123
Broadway, NSW 2007
Australia
+61 2 9514 7719 (Phone)
+61 2 9514 7711 (Fax)

HOME PAGE: http://www.business.uts.edu.au/finance/

Samuel Chege Maina

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

Haymarket
Sydney, NSW 2007
Australia

Christina Sklibosios Nikitopoulos

University of Technology Sydney - Business School ( email )

15 Broadway, Ultimo
Sydney 2007, New South Wales
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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