Modelling the Evolution of Credit Spreads using the Cox Process within the HJM Framework: A CDS Option Pricing Model

Quantitative Finance Research Centre Research Paper No. 232

27 Pages Posted: 3 Aug 2010 Last revised: 22 Oct 2010

See all articles by Carl Chiarella

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group

Viviana Fanelli

affiliation not provided to SSRN

Silvana Musti

University of Foggia

Date Written: October 1, 2008

Abstract

In this paper a simulation approach for defaultable yield curves is developed within the Heath et al. (1992) framework. The default event is modelled using the Cox process where the stochastic intensity represents the credit spread. The forward credit spread volatility function is affected by the entire credit spread term structure. The paper provides the defaultable bond and CDS option price in a probability setting equipped with a subfiltration structure. The Euler-Maruyama stochastic integral approximation and the Monte Carlo method are applied to develop a numerical algorithm for pricing. Finally, the Antithetic Variables technique is used to reduce the variance of CDSO estimations.

Keywords: HJM Model, Cox Process, Monte Carlo Method, Bond Price, CDS Option

JEL Classification: C63, G13, G33

Suggested Citation

Chiarella, Carl and Viviana Fanelli, Viviana and Musti, Silvana, Modelling the Evolution of Credit Spreads using the Cox Process within the HJM Framework: A CDS Option Pricing Model (October 1, 2008). Quantitative Finance Research Centre Research Paper No. 232, Available at SSRN: https://ssrn.com/abstract=1352114 or http://dx.doi.org/10.2139/ssrn.1352114

Carl Chiarella (Contact Author)

University of Technology, Sydney - UTS Business School, Finance Discipline Group ( email )

PO Box 123
Broadway, NSW 2007
Australia
+61 2 9514 7719 (Phone)
+61 2 9514 7711 (Fax)

HOME PAGE: http://www.business.uts.edu.au/finance/

Viviana Viviana Fanelli

affiliation not provided to SSRN ( email )

Silvana Musti

University of Foggia ( email )

Largo Papa Giovanni Paolo
Foggia, 71100
Italy

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