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

See all articles by Donatien Hainaut

Donatien Hainaut

Université Catholique de Louvain

Olivier Le Courtois

EM Lyon (Ecole de Management de Lyon) - Department of Economics, Finance, Control

Date Written: February 2, 2013

Abstract

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

Hainaut, Donatien and Le Courtois, Olivier Arnaud, An Intensity Model for Credit Risk with Switching Lévy Processes. (February 2, 2013). Quantitative Finance, 14 (8), 2014. Available at SSRN: https://ssrn.com/abstract=2210859 or http://dx.doi.org/10.2139/ssrn.2210859

Donatien Hainaut (Contact Author)

Université Catholique de Louvain ( email )

Voie du Roman Pays 20,
Louvain La Neuve, 1348
Belgium

Olivier Arnaud Le Courtois

EM Lyon (Ecole de Management de Lyon) - Department of Economics, Finance, Control ( email )

23, av. Guy de Collongue
69134 Ecully Cedex
France

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