Optimal valuation of American callable credit default swaps under drawdown of Lévy insurance risk process

DOI10.1016/J.INSMATHECO.2020.04.011zbMATH Open1446.91070arXiv1904.10063OpenAlexW3026165196MaRDI QIDQ784432FDOQ784432

Authors: Zbigniew Palmowski, Budhi A. Surya 

Publication date: 3 August 2020

Published in: Insurance Mathematics \& Economics (Search for Journal in Brave)

Abstract: This paper discusses the valuation of credit default swaps, where default is announced when the reference asset price has gone below certain level from the last record maximum, also known as the high-water mark or drawdown. We assume that the protection buyer pays premium at fixed rate when the asset price is above a pre-specified level and continuously pays whenever the price increases. This payment scheme is in favour of the buyer as she only pays the premium when the market is in good condition for the protection against financial downturn. Under this framework, we look at an embedded option which gives the issuer an opportunity to call back the contract to a new one with reduced premium payment rate and slightly lower default coverage subject to paying a certain cost. We assume that the buyer is risk neutral investor trying to maximize the expected monetary value of the option over a class of stopping time. We discuss optimal solution to the stopping problem when the source of uncertainty of the asset price is modelled by L'evy process with only downward jumps. Using recent development in excursion theory of L'evy process, the results are given explicitly in terms of scale function of the L'evy process. Furthermore, the value function of the stopping problem is shown to satisfy continuous and smooth pasting conditions regardless of regularity of the sample paths of the L'evy process. Optimality and uniqueness of the solution are established using martingale approach for drawdown process and convexity of the scale function under Esscher transform of measure. Some numerical examples are discussed to illustrate the main results.

Full work available at URL: https://arxiv.org/abs/1904.10063

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zbMATH Keywords

swapscredit riskcredit default swapsdrawdownLévy process

Mathematics Subject Classification ID

Processes with independent increments; Lévy processes (60G51) Actuarial mathematics (91G05) Derivative securities (option pricing, hedging, etc.) (91G20) Credit risk (91G40) Stopping times; optimal stopping problems; gambling theory (60G40)

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• Fair valuation of Lévy-type drawdown-drawup contracts with general insured and penalty functions
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• Stochastic modeling and fair valuation of drawdown insurance
• Restructuring risk in credit default swaps: an empirical analysis

Cited In (6)

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• COVID-19 and credit risk: a long memory perspective
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• Fair valuation of Lévy-type drawdown-drawup contracts with general insured and penalty functions

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