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
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: Suggested Citation
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