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A structural model for credit risk with switching processes and synchronous jumps

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Hainaut, Donatien [UCL] Colwell, David B.

This paper studies a switching regime version of Merton's structural model for the pricing of default risk. The default event depends on the total value of the firm's asset modeled by a switching Lévy process. The novelty of this approach is to consider that firm's asset jumps synchronously with a change in the regime. After a discussion of dynamics under the risk neutral measure, two models are presented. In the first one, the default happens at bond maturity, when the firm's value falls below a predetermined barrier. In the second version, the firm can enter bankruptcy at multiple predetermined discrete times. The use of a Markov chain to model switches in hidden external factors makes it possible to capture the effects of changes in trends and volatilities exhibited by default probabilities. With synchronous jumps, the firm's asset and state processes are no longer uncorrelated. Finally, some econometric evidence that switching Lévy processes, with synchronous jumps, fit well historical time series is provided.

Document type Article de périodique (Journal article) – Article de recherche
Access type Accès libre
Publication date 2014
Language Anglais
Journal information "The European Journal of Finance" - Vol. 22, no.11, p. 1040-1062 (2014)
Peer reviewed yes
Publisher Routledge (Abingdon)
issn 1351-847X
e-issn 1466-4364
Publication status Publié
Affiliation Rennes School of Business - Finance
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Bibliographic reference Hainaut, Donatien ; Colwell, David B.. A structural model for credit risk with switching processes and synchronous jumps. In: The European Journal of Finance, Vol. 22, no.11, p. 1040-1062 (2014)
Permanent URL http://hdl.handle.net/2078/185385