Linear credit risk models

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Publication:2282965



Abstract: We introduce a novel class of credit risk models in which the drift of the survival process of a firm is a linear function of the factors. The prices of defaultable bonds and credit default swaps (CDS) are linear-rational in the factors. The price of a CDS option can be uniformly approximated by polynomials in the factors. Multi-name models can produce simultaneous defaults, generate positively as well as negatively correlated default intensities, and accommodate stochastic interest rates. A calibration study illustrates the versatility of these models by fitting CDS spread time series. A numerical analysis validates the efficiency of the option price approximation method.


In this extensive paper, the authors present a new linear credit risk model. This approach has the flexibility to deal with the multi-named model associated with negatively correlated default intensities. Within this environment, a single-name model is defined, referred to as the linear hypercube (LHC). A comparison of this is made with the one-factor affine default intensity model. A useful review of the current literature is given. An approximation approach for the pricing of European-styled options on underlying assets that are exposed credit risk is described. This is aided by an application of the Stone-Weierstrass theorem. Interestingly, from this, the price of a CDS option may be approximated by polynomials appearing in the factors. The method may also be used to incorporate CVA in the pricing. The paper continues with an empirical analysis of the LHC model focusing on the efficiency of the approximation techniques.



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