Insider trading in an equilibrium model with default: a passage from reduced-form to structural modelling (Q2463723)

In the valuation of credit derivatives, the key issue is the calculation of probabilities associated to the default event for which the product is written. The authors study an equilibrium model for the pricing of a defaultable zero coupon bond issued by a firm. The market consists of a risk-neutral informed agent (insider), noise traders, and a market maker who sets the price using the total order. Insider has extra information about the default time. The market maker chooses a pricing rule and the insider chooses a trading strategy, where the cumulative demand of the noise traders is modeled by a Brownian motion. The main result gives existence and characterization of the equilibrium. It is shown that in equilibrium the insider's trades cannot be seen in the market. More exactly, it is shown that the equilibrium total order process is a Brownian motion in its own filtration, hence insider's trades are inconspicuous. Also, it is proved that the default time becomes the first time that the continuous total order process falls below a certain barrier.