An Intensity Model for Credit Risk with Switching Lévy Processes.
Quantitative Finance, 14 (8), 2014
22 Pages Posted: 3 Feb 2013 Last revised: 8 Nov 2014
Date Written: February 2, 2013
We develop a switching regime version of the intensity model for credit risk pricing. The default event is specified by a Poisson process whose intensity is modeled by a switching Lévy process. This model presents several interesting features. Firstly, as Lévy processes encompass numerous jump processes, our model can duplicate sudden jumps observed in credit spreads. Also, due to the presence of jumps, probabilities do not vanish at very short maturities, contrary to models based on Brownian dynamics. Furthermore, as parameters of the Lévy process are modulated by a hidden Markov chain, our approach is well suited to model changes of volatility trends in credit spreads, related to modifications of unobservable economic factors.
Keywords: Regime-switching model, Markov chain, Lévy process
JEL Classification: C02
Suggested Citation: Suggested Citation