A Structural Model for Credit Risk with Markov Modulated Lévy Processes and Synchronous Jumps

Forthcoming in European Journal of Finance

18 Pages Posted: 4 Feb 2013 Last revised: 26 Oct 2014

See all articles by Donatien Hainaut

Donatien Hainaut

Université Catholique de Louvain

David B. Colwell

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Date Written: February 4, 2013

Abstract

This paper presents a switching regime version of the Merton's structural model for the pricing of default risk. The default event depends on the total value of the firm's asset modeled by a Markov modulated Lévy process. The novelty of our approach is to consider that firm's asset jumps synchronously with a change in the regime. After a discussion of dynamics under the risk neutral measure, we present two models. In the first one, the default occurs at bond maturity if the firm's value falls below a predetermined barrier. In the second version, the company can bankrupt at multiple predetermined discrete times. The use of a Markov chain to model switches in hidden external factors makes it possible to capture the effects of changes in trends and volatilities exhibited by default probabilities. Finally, with synchronous jumps, the firm's asset and state processes are no longer uncorrelated.

Keywords: credit risk, lévy processes, switching regimes

JEL Classification: C02, G13

Suggested Citation

Hainaut, Donatien and Colwell, David B., A Structural Model for Credit Risk with Markov Modulated Lévy Processes and Synchronous Jumps (February 4, 2013). Forthcoming in European Journal of Finance, Available at SSRN: https://ssrn.com/abstract=2211424 or http://dx.doi.org/10.2139/ssrn.2211424

Donatien Hainaut (Contact Author)

Université Catholique de Louvain ( email )

Voie du Roman Pays 20,
Louvain La Neuve, 1348
Belgium

David B. Colwell

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+61 (2) 9385 5851 (Phone)
+61 (2) 9385 6347 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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