PDE models for the pricing of a defaultable coupon-bearing bond under an extended JDCEV model (Q2045957)
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English | PDE models for the pricing of a defaultable coupon-bearing bond under an extended JDCEV model |
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PDE models for the pricing of a defaultable coupon-bearing bond under an extended JDCEV model (English)
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16 August 2021
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The paper addresses the problem of computing the price of a coupon-bearing bond subject to default by relying on PDE methods. The authors adopt the extended JDCEV (\textit{jump-to-default CEV}) model first introduced in [\textit{P. Carr} and \textit{V. Linetsky}, Finance Stoch. 10, No. 3, 303--330 (2006; Zbl 1101.60057)], also allowing for stochastic interest rates possibly taking negative values. The default time is modelled via an intensity-based approach, where the intensity is assumed to be an affine function (with time-dependent coefficients) of the instantaneous variance of the stock price. The interest rate follows an Ornstein-Uhlenbeck process, correlated with the Brownian motion driving the stock price process. The pricing problem consists in evaluating a defaultable coupon bond, with a fixed recovery rate. By relying on the Feynman-Kač formula, the pricing problem is formulated as a Cauchy problem, which admits at least a local solution. The PDE is solved numerically by first considering a bounded domain and then applying a Lagrange-Galerkin method. More precisely, a second order Crank-Nicolson characteristics scheme is used for the time discretization and a piecewise quadratic Lagrange finite element method for the spatial approximation. The paper includes some numerical experiments to demonstrate the feasibility and the satisfactory performance of the proposed approach.
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defaultable coupon bond
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JDCEV pricing model
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PDE formulation
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semi-Lagrangian method
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quadratic Lagrange finite elements
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