MLV3 Cox

Credit Risk III
1
III. Cox Processes and Extensions
1. Construction of Default Time with a given Intensity
2. Properties
2.1 Conditional expectation
2.2. Choice of ltration
2.3. Key Lemma
3. Defaultable Assets
2
Default Time with a given Intensity
Let (, G, P) be a probability space endowed with a ltration F.
A nonnegative F-adapted process is given.
3
We assume that there exists a random variable , independent of F
,
with an exponential law: P( t) = e
t
.
4
,
t
.
We dene the random time as the rst time when the process
t
=
_
t
0

s
ds is above the random level , i.e.,
= inf {t 0 :
t
}.
5
,
t
.
We dene the random time as the rst time when the process
t
=
_
t
0

s
ds is above the random level , i.e.,
= inf {t 0 :
t
}.
In particular, { > s} = {
s
< }.
6
Properties
Conditional Expectations
The conditional distribution function of given the -eld F
t
is for t s
P( > s|F
t
) = exp (
s
) .
7
Properties
Conditional Expectations
The conditional distribution function of given the -eld F
t
is for t s
P( > s|F
t
) = exp (
s
) .
Proof : For s t,
P( > s|F
t
) = P(
s
< |F
t
)
= (
s
)
where (x) = P(x < ).
8
Choice of ltration
We write as before H
t
= 11
{t}
and H
t
= (H
s
: s t). We introduce the
ltration G
t
= F
t
H
t
, that is, the enlarged ltration generated by the
underlying ltration F and the process H. (We denote by F the original
Filtration and by G the enlarGed one.)
9
Choice of ltration
t
= 11
{t}
and H
t
= (H
s
ltration G
t
= F
t
H
t
If G
t
G
t
, then G
t
{ > t} = B
t
{ > t} for some event B
t
F
t
.
10
Choice of ltration
t
= 11
{t}
and H
t
= (H
s
ltration G
t
= F
t
H
t
If G
t
G
t
, then G
t
{ > t} = B
t
{ > t} for some event B
t
F
t
.
Therefore any G
t
-measurable random variable Y
t
satises
11
{>t}
Y
t
= 11
{>t}
y
t
, where y
t
is an F
t
-measurable random
variable.
11
Key lemma
Let Y be an integrable r.v. Then,
11
{>t}
E(Y |G
t
) = 11
{>t}
E(Y 11
{>t}
|F
t
)
E(11
{>t}
|F
t
)
= 11
{>t}
e
t
E(Y 11
{>t}
|F
t
).
12
Key lemma
11
{>t}
E(Y |G
t
) = 11
{>t}
E(Y 11
{>t}
|F
t
)
E(11
{>t}
|F
t
)
= 11
{>t}
e
t
E(Y 11
{>t}
|F
t
).
If X F
T
E(X11
{>T}
|G
t
) = 11
{>t}
e
t
E(Xe
T
|F
t
).
13
Key lemma
11
{>t}
E(Y |G
t
) = 11
{>t}
E(Y 11
{>t}
|F
t
)
E(11
{>t}
|F
t
)
= 11
{>t}
e
t
E(Y 11
{>t}
|F
t
).
If X F
T
E(X11
{>T}
|G
t
) = 11
{>t}
e
t
E(Xe
T
|F
t
).
The process is called the intensity of .
14
In particular, one an check that
(i) The process L
t
= 11
t<
e
t
= (1 H
t
)e
t
is a martingale
(ii) Let X be an F
-measurable r.v.. Then

E(X|G
t
) = E(X|F
t
) .
15
Proof: (ii) Let X be an F
-measurable r.v. It suces to check that

E(B
t
h( t)X) = E(B
t
h( t)E(X|F
t
))
for any B
t
F
t
and any h = 11
[0,a]
. For t a, the equality is obvious. For
t > a, we have
E(B
t
11
{a}
E(X|F
t
)) = E(B
t
E(X|F
t
)E(11
{a}
|F
))
= E(E(B
t
X|F
t
)E(11
{a}
|F
t
))
= E(XB
t
E(11
{a}
|F
t
)) = E(B
t
X11
{a}
)
as expected.
16
We now compute the expectation of the value at time of a predictable
process.
(i) If h is an F-predictable (bounded) process then
E(h
|G
t
) = E
_
_

t
h
u
u
exp
_
t

u
_
du
F
t
_
11
{>t}
+h
11
{t}
.
17
process.
E(h
|G
t
) = E
_
_

t
h
u
u
exp
_
t

u
_
du
F
t
_
11
{>t}
+h
11
{t}
.
In particular
E(h
) = E
_
_

0
h
u
u
exp
_
u
) du
_
18
process.
E(h
|G
t
) = E
_
_

t
h
u
u
exp
_
t

u
_
du
F
t
_
11
{>t}
+h
11
{t}
.
In particular
E(h
) = E
_
_

0
h
u
u
exp
_
u
) du
_
(ii) The process (M
t
:= H
t

_
t
0

s
ds, t 0) is a G-martingale.
19
process.
E(h
|G
t
) = E
_
_

t
h
u
u
exp
_
t

u
_
du
F
t
_
11
{>t}
+h
11
{t}
.
In particular
E(h
) = E
_
_

0
h
u
u
exp
_
u
) du
_
(ii) The process (M
t
:= H
t

_
t
0

s
ds, t 0) is a G-martingale.
(iii) The martingale L
t
= 11
t<
e
t
satises dL
t
= L
t
dM
t
.
20
Defaultable Assets
Let B(t, T) be the price at time t of a default-free bond paying 1 at
maturity T satises
B(t, T) = E
Q
_
exp
_
_
T
t
r
s
ds
_
F
t
_
.
21
Defaultable Assets
Let B(t, T) be the price at time t of a default-free bond paying 1 at
maturity T satises
B(t, T) = E
Q
_
exp
_
_
T
t
r
s
ds
_
F
t
_
.
The market price D(t, T) of a defaultable zero-coupon bond with maturity
T is
D(t, T) = E
Q
_
11
{T<}
exp
_
_
T
t
r
s
ds
_
G
t
_
= 11
{>t}
E
Q
_
exp
_
_
T
t
[r
s
+
Q
s
] ds
_
F
t
_
.
22
Promised payo:
Let X F
T
E
Q
_
X exp
_
T
t
r
s
ds|G
t
_
= 11
t<
E
Q
_
X exp
_
T
t
(r
s
+
s
)ds|F
t
_
is also called the spread.
23
Recovery paid at Maturity
We consider a contract which pays R
at date T, if T where R is an
F-adapted process and no payment in the case > T. We also assume
that the interest rate is null.
24
that the interest rate is null. The price at time t of this contract is
S
t
= E(R
11
T
|G
t
) = R
11
t
+ 11
t<
E(R
11
t<T
|G
t
)
25
S
t
= E(R
11
T
|G
t
) = R
11
t
+ 11
t<
E(R
11
t<T
|G
t
)
= R
11
t
+ 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
26
S
t
= E(R
11
T
|G
t
) = R
11
t
+ 11
t<
E(R
11
t<T
|G
t
)
= R
11
t
+ 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= R
11
t
+ 11
t<
e
t
E(
_
T
t
R
u
e
u
du|F
t
)
27
S
t
= E(R
11
T
|G
t
) = R
11
t
+ 11
t
E(R
11
t<T
|G
t
)
= R
11
t
+ 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= R
11
t
+ 11
t<
e
t
E(
_
T
t
R
u
e
u
du|F
t
)
=
_
t
0
R
u
dH
u
+L
t
_
_
t
0
R
u
e
u
du +m
R
t
_
where m
R
t
= E(
_
T
0
R
u
e
u
du|F
t
)
28
S
t
= E(R
11
<T
|G
t
) = R
11
<t
+ 11
t<
E(R
11
t<<T
|G
t
)
= R
11
<t
+ 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= R
11
<t
+ 11
t<
e
t
E(
_
T
t
R
u
e
u
du|F
t
)
=
_
t
0
R
u
dH
u
+L
t
_
_
t
0
R
u
e
u
du +m
R
t
_
where m
R
t
= E(
_
T
0
R
u
e
u
du|F
t
) is an F, hence a G martingale.
29
We assume here that F-martingales are continuous. From dL
t
= L
t
dM
t
and integration by parts formula we deduce that
dS
t
= R
t
(dH
t

t
(1 H
t
)dt) S
t
dM
t
+L
t
dm
R
t
30
t
= L
t
dM
t
dS
t
= R
t
(dH
t

t
(1 H
t
)dt) S
t
dM
t
+L
t
dm
R
t
= (R
t
S
t
) dM
t
+L
t
dm
R
t
31
t
= L
t
dM
t
dS
t
= R
t
(dH
t

t
(1 H
t
)dt) S
t
dM
t
+L
t
dm
R
t
= (R
t
S
t
) dM
t
+L
t
dm
R
t
In the case R
t
is a constant R and with a deterministic interest rate
S
t
= 1 11
{>t}
(R 1)
_
1 E
_
exp
_
T
t
Q
s
ds
F
t
__
.
32
Recovery paid at Default
If the payment R is done at time
S
t
= 11
t<
E(R
11
t<<T
|G
t
) = 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
33
S
t
= 11
t<
E(R
11
t<<T
|G
t
) = 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= L
t
_
_
t
0
R
u
e
u
du +m
R
t
_
34
S
t
= 11
t<
E(R
11
t<<T
|G
t
) = 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= L
t
_
_
t
0
R
u
e
u
du +m
R
t
_
where m
R
t
= E(
_
T
0
R
u
e
u
du|F
t
).
35
S
t
= 11
t<
E(R
11
t<<T
|G
t
) = 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= L
t
_
_
t
0
R
u
e
u
du +m
R
t
_
where m
R
t
= E(
_
T
0
R
u
e
u
du|F
t
).
dS
t
= R
t
t
(1 H
t
)dt S
t
dM
t
+L
t
dm
R
t
.
36
S
t
= 11
t<
E(R
11
t<<T
|G
t
) = 11
t<
e
t
E(
_
T
t
R
u
dF
u
|F
t
)
= L
t
_
_
t
0
R
u
e
u
du +m
R
t
_
where m
R
t
= E(
_
T
0
R
u
e
u
du|F
t
).
dS
t
= R
t
t
(1 H
t
)dt S
t
dM
t
+L
t
dm
R
t
.
The process S
t
+
_
t
0
R
s
(1 H
s
)
s
ds is a martingale.
37
Price and Hedging a defaultable call
The savings account Y
0
t
= 1, a risky asset with risk-neutral dynamics
dY
t
= Y
t
dW
t
and a DZC of maturity T with price D(t, T) are traded.
38
0
t
dY
t
= Y
t
dW
t
The reference ltration is that of the Brownian motion W.
39
0
t
dY
t
= Y
t
dW
t
The reference ltration is that of the Brownian motion W. Then,
D(t, T) = L
t
Q( > T|F
t
) = L
t
m
t
with m
t
= Q( > T|F
t
) = E(e
T
|F
t
).
40
0
t
dY
t
= Y
t
dW
t
D(t, T) = L
t
Q( > T|F
t
) = L
t
m
t
with m
t
= Q( > T|F
t
) = E(e
T
|F
t
).
The price of a defaultable call with payo 11
T<
(Y
T
K)
+
is
C
t
= E(11
T<
(Y
T
K)
+
|G
t
) = 11
t<
e
t
E(e
T
(Y
T
K)
+
|F
t
)
41
0
t
dY
t
= Y
t
dW
t
D(t, T) = L
t
Q( > T|F
t
) = L
t
m
t
with m
t
= Q( > T|F
t
) = E(e
T
|F
t
).
T<
(Y
T
K)
+
is
C
t
= E(11
T<
(Y
T
K)
+
|G
t
) = 11
t<
e
t
E(e
T
(Y
T
K)
+
|F
t
)
= L
t
m
Y
t
with m
Y
t
= E(e
T
(Y
T
K)
+
|F
t
).
42
0
t
dY
t
= Y
t
dW
t
D(t, T) = L
t
Q( > T|F
t
) = L
t
m
t
with m
t
= Q( > T|F
t
) = E(e
T
|F
t
).
T<
(Y
T
K)
+
is
C
t
= E(11
T<
(Y
T
K)
+
|G
t
) = 11
t<
e
t
E(e
T
(Y
T
K)
+
|F
t
)
= L
t
m
Y
t
with m
Y
t
= E(e
T
(Y
T
K)
+
|F
t
), hence
dC
t
= L
t
dm
Y
t
m
Y
t
L
t
dM
t
43
In the particular case where is deterministic, m
t
= e
T
and dm
t
= 0.
Therefore, D(t, T) = m
t
L
t
= L
t
e
T
and
dD(t, T) = m
t
dL
t
= m
t
L
t
dM
t
= e
T
L
t
dM
t
.
44
t
= e
T
and dm
t
= 0.
t
L
t
= L
t
e
T
and
dD(t, T) = m
t
dL
t
= m
t
L
t
dM
t
= e
T
L
t
dM
t
.
Furthermore,
m
Y
t
= e
T
E((Y
T
K)
+
|F
t
) = e
T
C
Y
t
where C
Y
is the price of a call in the Black Scholes model.
45
t
= e
T
and dm
t
= 0.
t
L
t
= L
t
e
T
and
dD(t, T) = m
t
dL
t
= m
t
L
t
dM
t
= e
T
L
t
dM
t
.
Furthermore,
m
Y
t
= e
T
E((Y
T
K)
+
|F
t
) = e
T
C
Y
t
where C
Y
This quantity is C
Y
t
= C
Y
(t, Y
t
) and satises dC
Y
t
=
t
dY
t
where
t
is
the Delta-hedge (
t
=
y
C
Y
(t, Y
t
)).
46
t
= e
T
and dm
t
= 0.
t
L
t
= L
t
e
T
and
dD(t, T) = m
t
dL
t
= m
t
L
t
dM
t
= e
T
L
t
dM
t
.
Furthermore,
m
Y
t
= e
T
E((Y
T
K)
+
|F
t
) = e
T
C
Y
t
where C
Y
This quantity is C
Y
t
= C
Y
(t, Y
t
) and satises dC
Y
t
=
t
dY
t
where
t
is
the Delta-hedge (
t
=
y
C
Y
(t, Y
t
)).
C
t
= L
t
m
Y
t
= 11
t<
e
t
e
T
C
Y
(t, Y
t
)
= L
t
e
T
C
Y
(t, Y
t
) = D(t, T)C
Y
(t, Y
t
)
47
From
C
t
= D(t, T)C
Y
(t, Y
t
)
we deduce
dC
t
= e
T
(L
t
dC
Y
t
+C
Y
t
dL
t
) = e
T
(L
t
t
dY
t
C
Y
t
L
t
dM
t
)
= e
T
(L
t
t
dY
t
C
Y
t
L
t
dM
t
)
48
From
C
t
= D(t, T)C
Y
(t, Y
t
)
we deduce
dC
t
= e
T
(L
t
dC
Y
t
+C
Y
t
dL
t
) = e
T
(L
t
t
dY
t
C
Y
t
L
t
dM
t
)
= e
T
(L
t
t
dY
t
C
Y
t
L
t
dM
t
)
Therefore, using that dD(t, T) = m
t
dL
t
= e
T
L
t
dM
t
we get
dC
t
= e
T
L
t
t
dY
t
+C
Y
t
dD(t, T) = e
T
L
t
t
dY
t
+
C
t
D(t, T)
dD(t, T))
49
From
C
t
= D(t, T)C
Y
(t, Y
t
)
we deduce
dC
t
= e
T
(L
t
dC
Y
t
+C
Y
t
dL
t
) = e
T
(L
t
t
dY
t
C
Y
t
L
t
dM
t
)
= e
T
(L
t
t
dY
t
C
Y
t
L
t
dM
t
)
Therefore, using that dD(t, T) = m
t
dL
t
= e
T
L
t
dM
t
we get
dC
t
= e
T
L
t
t
dY
t
+C
Y
t
dD(t, T) = e
T
L
t
t
dY
t
+
C
t
D(t, T)
dD(t, T))
hence, an hedging strategy consists of holding
C
t
D(t,T)
DZCs.
50
In the general case, one obtains
dC
t
=
C
t
D(t, T)
dD(t, T) L
m
Y
t
m
t
dm
t
+Ldm
Y
t
51
In the general case, one obtains
dC
t
=
C
t
D(t, T)
dD(t, T) L
t
m
Y
t
m
t
dm
t
+L
t
dm
Y
t
An hedging strategy consists of holding
C
t
D(t,T)
DZCs.
52

MLV3 Cox

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