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A Spread-Return Mean-Reverting Model for Credit Spread Dynamics

16 Pages Posted: 24 Feb 2014  

Brendan O’Donoghue

Stanford University - Department of Electrical Engineering

Matthew Peacock

Credit Suisse AG

Shinghoi (Jacky) Lee

Quantitative Strategies - Investment Banking Division - Credit Suisse Group

Luca Capriotti

Quantitative Strategies - Investment Banking Division - Credit Suisse Group; University College London

Date Written: February 22, 2014

Abstract

In this paper we propose a novel, analytically tractable, one-factor stochastic model for the dynamics of credit default swap (CDS) spreads and their returns, which we refer to as the spread-return mean-reverting (SRMR) model. The SRMR model can be seen as a hybrid of the Black-Karasinski model on spreads and the Ornstein-Uhlenbeck model on spread returns, and is able to capture empirically observed properties of CDS spreads and returns, including spread mean-reversion, heavy tails of the return distribution, and return autocorrelations. Although developed for modeling CDS spreads, the SRMR model has applications for many other stochastic processes with similar empirical properties, including more general rate processes.

Suggested Citation

O’Donoghue, Brendan and Peacock, Matthew and Lee, Shinghoi (Jacky) and Capriotti, Luca, A Spread-Return Mean-Reverting Model for Credit Spread Dynamics (February 22, 2014). Available at SSRN: https://ssrn.com/abstract=2399915 or http://dx.doi.org/10.2139/ssrn.2399915

Brendan O’Donoghue

Stanford University - Department of Electrical Engineering ( email )

Stanford, CA 94305-6104
United States

Matthew Peacock

Credit Suisse AG ( email )

CRTI 4
P.O. Box
Zurich, CH-8070
Switzerland

Shinghoi Lee

Quantitative Strategies - Investment Banking Division - Credit Suisse Group ( email )

Eleven Madison Avenue
New York, NY 10010
United States

Luca Capriotti (Contact Author)

Quantitative Strategies - Investment Banking Division - Credit Suisse Group ( email )

Eleven Madison Avenue
New York, NY 10010
United States

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

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