Pricing defaultable bonds: a new model combining structural information with the reduced-form approach

Luca Vincenzo Ballestra

Dipartimento di Scienze Sociali D. Serrani, Universit` Politecnica delle Marche, Piazza Martelli 8, 60121 Ancona, Italy, a Ph. N. +39-071-2207251, FAX N. +39-071-2207150, E-mail: l.v.ballestra@univpm.it

Graziella Pacelli
Dipartimento di Scienze Sociali D. Serrani, Universit` Politecnica delle Marche, Piazza Martelli 8, 60121 Ancona, Italy, a Ph. N. +39-071-2207050, FAX N. +39-071-2207150, E-mail: g.pacelli@univpm.it

Abstract We propose a new model to price defaultable bonds which incorporates features of both structural and reduced-form models of credit risk. The main novelty of the model is that the default intensity is described by an additional stochastic dierential equation coupled with the process of the rms asset value. Such an approach allows to incorporate structural information as well as to capture the complex dynamics of unexpected default due to not rmspecic variables. From the practical standpoint, the model proposed oers great exibility to describe credit spreads and allows to correctly reproduce important stylized facts. In particular yield-spread curves of many dierent shape can be obtained, including double humped term curves, which reveals to be crucial in order to accurately t realized market data. Finally the model is also mathematically tractable, as a closed-form approximate solution can be obtained using a perturbation approach in conjunction with the Laplace transform. Extensive numerical simulation is presented showing that this formula is accurate and computationally ecient. JEL Classication Codes: G13, C63. Key Words: defaultable bond; credit risk; asymptotic expansion.

Introduction

In the technical literature models of default risk are mainly developed following two common approaches: the structural approach and the reduced-form approach. According to structural models the default event is related to one or more rmspecic variables. Usually it is assumed that default occurs when the value of the assets of the rm falls below a threshold level that depends on the outstanding debt [6], [8], [11], [20], [23], [34], [36], [43]. These models can also incorporate other rm-specic variables, such as, for instance, the seniority of the debt [6], tax benets [3], [32], and liquidation costs [3], [32], [33]. The structural approach has the advantage of using data and information that truly reect the balance sheet of the rm. Nevertheless, if the value of the total assets of the rm is modeled as a continuous-time process, default turns out to be a predictable event, and the high credit spreads that are frequently observed for short-term maturities cannot be obtained [30]. In order to account for high short-term spreads, Zhou [43] proposes a structural model of default with jumps in the value of the assets of the rm. This approach however lacks analytical tractability, which makes it dicult to estimate the model parameters from observed credit spreads. Following the reduced-form approach (see for instance [14], [15], [16], [17], [24], [25], [26], [27], [28], [29], [31], [40]), the default event is modeled as the rst jump of a counting process whose intensity, termed intensity of default (or default intensity), is not related to any rm specic variable, but is specied exogenously. Usually the intensity of default is described by a stochastic dierential equation in which the parameters are determined by direct calibration to market data. Reduced-form models are capable of predicting high short-term credit spreads, nevertheless they do not take into account any information about the capital structure of the rm. In few words we can say that reduced-form models are successful where structural models fail, and viceversa. Thats the reason why, also very recently, some researchers have focused their eorts on developing hybrid models of default risk, i.e. models that incorporate features of both the structural and the reduced-form approach. One of such hybrid models is proposed by Madan and Unal in [35]. In particular this work is based on the reduced-form approach, however the intensity of default, instead of being prescribed exogenously, is specied as a function of the rms equity value. Another hybrid model of credit risk is proposed by Cathcart and El-Jahel in [10]. Here the mechanism of default is explained by introducing a signaling variable, which is a ctitious variable that somehow incorporates all the information about the capital structure of the rm. Following the structural approach it is assumed that default occurs with certainty when the signaling variable falls below a xed threshold level. However the default event can also occur as the rst jump of a counting process whose intensity is specied as a function of the signaling variable 2

itself and the stochastic spot interest rate. We also mention that in [9] Cathcart and El-Jahel had already proposed a hybrid model of credit risk where the intensity of default is specied as a function of the stochastic spot interest rate only. In the models proposed in [9], [10], [35], the default intensity is prescribed as a deterministic function of some structural variable (in [10] it is also a function of the interest rate). However we note that the intensity of default represents the probability of unexpected default (default occurring in an innitesimal time), and as such should also reect the inter-temporal variations of external factors (on which the rm has no control), such as, for instance, the public policy, the business trend, or the macroeconomic environment. Therefore, in this paper, in order to take into account the complex dynamics of such external variables, as well as to incorporate structural information, we propose a hybrid model of default risk where the default intensity is described by an additional stochastic dierential equation coupled with the process of the rms asset value. In particular we assume that default occurs with certainty when the rms asset value, which is modeled as a geometric Brownian motion, falls below a xed threshold level. However, the default event can also occur as the rst jump of a counting process whose intensity is described by a generalized Ornstein-Uhlenbeck stochastic dierential equation. In addition, in order to take into account the complex interaction between the dynamics of unexpected default and the rms capital structure, the long-run mean of the default intensity process is described by an appropriate function of the rms asset value. The model obtained has the following features, which clearly appear desirable both for theoretical and economical reasons: 1) the rms capital structure is adequately taken into account; in particular the lower barrier on the rms asset value allows to model the fact that default occurs when the rms asset value is insucient to repay the existing debt; 2) the default intensity (i.e. the probability of unexpected default) is specied by an additional stochastic dierential equation, which allows to incorporate complex inter-temporal dynamics of unexpected default due to external factors; 3) the dependence of the probability of unexpected default on the rms asset value is taken into account. To the best of our knowledge, in the technical literature, a model of default risk which incorporates all the above three features is still lacking. Furthermore, from the practical standpoint, our approach oers great exibility to describe credit spreads and allows to correctly reproduce important stylized facts. In particular, in accordance with previous empirical ndings (see for instance [19], [39]), it is possible to have, for speculative-grade bonds, downward sloping term-structures, and, for investment-grade bonds, term-structures that are upward sloping for short maturities and rather at for longer maturities. Moreover double humped term structures can also be obtained, which reects the complex interaction between the rms capital structure and the dynamics of unexpected default, and reveals to be crucial in order to properly t realized market data in a practical 3

test-case considered in Section 4. Note that term structures with multiple peaks are sometimes experienced in the nancial markets (see [7], [18], [22], [37], [39]), but are not observed using the hybrid models proposed in [9], [10], [35]. It is also worth noticing that the model proposed in this paper recovers the model developed in [35] as a limit case when the parameters used to dene the drift of the default intensity process converge to appropriate values. Finally our model is also mathematically tractable, as a closed-form approximate solution can be obtained using a perturbation approach in conjunction with the Laplace transform. Extensive numerical simulation is presented showing that this formula is accurate and computationally ecient. Moreover, as described in appendix, an approximate closed-form solution can also be obtained if the Vasicek-type process used to model the default intensity is replaced with an analogous CIR-type process. The remainder of the paper is organized as follows: in Section 2 we describe the mathematical model; in Section 3 we derive the closed-form approximate solution; in Section 4 we assess the validity of the model proposed and test the computational eciency of the closed-form approximate solution; nally in Section 5 some conclusions are drawn.

The mathematical model

The model is based on the Vasicek stochastic process: dY (t) = a (Y (t) ) dt + kdW (t), (1)

where , a, and k are positive constant parameters that measure the long-run mean, the rate of mean reversion, and the volatility of Y (t) respectively, and W (t) is a standard Wiener process. Note that the stochastic dierential equation (1) does not ensure the positivity of Y (t). Nevertheless the Vasicek process is often employed to describe the intensity of default in reduced-form models of credit risk (see for instance [24], [25], [26], [27], [40]). In fact the possible occurrence of negative default intensities is accepted given the analytical tractability of the equation (1). Moreover the parameters a, , k are usually specied such that the process Y (t) takes negative values with very small probability. Finally in Appendix B is also considered an extension of the model presented in this section, where, at the place of the Vasicek process (1), we use the Cox-Ingersoll-Ross (CIR) square root process (as is well-known the CIR square root process cannot take negative values). Also in this case it is possible to derive a closed-form approximate solution, which is very similar to that obtained in Section 3. Let t0 denote the current time. Let V (t) denote the value at time t t0 of the assets of the rm. We assume that V (t) follows the stochastic dierential equation: 4

dV (t) = V (t)dt + V (t)dW (1) (t), with initial condition:

(2)

V (t0 ) = V0 ,

(3)

where V0 > 0, 0, > 0, and W (1) (t) is a standard Wiener process. We assume that default occurs with certainty when V (t) falls below a xed threshold level V smaller than V0 . Moreover, in analogy with reduced-form models, the default event can also occur as the rst jump of a counting process whose intensity is denoted by (t). In order to model (t) let us consider the following stochastic dierential equation: d(t) = a ((t) (V (t))) dt + kdW (2) (t), with initial condition:

(4)

(t0 ) = 0 , where (V (t)) is specied as follows: c logV (t) logV

(5)

(V (t)) = b +

2,

(6)

where 0 0, b 0, a > 0, c > 0, k > 0, and W (2) (t) is a standard Wiener process. Note that equations (4), (6) constitute a generalization of the Vasicek process (1). In particular the long-run mean of the default intensity is specied as a monotone decreasing function of the rms asset value. This choice aims to model the fact that the probability of default and the rms asset value are very frequently inversely proportional. We may also note that (V (t)) tends to innity as V (t) tends to the threshold level V . Looking at equation (6) the long-run mean of (t) is described by the parameters b and c. In particular the parameter c, which measures the inversely proportional dependence of (t) on (V (t)), introduces non-linearity. As a consequence it will not be possible to obtain an exact analytical solution of the model proposed, but some numerical approximation will be required. According to equations (4), (6) the dynamics of (t) can be considered as formed by two components: the long-run mean (V (t)) and the dynamics of (t) around (V (t)). The former appears to be a structural component since it depends solely 5

on the rms asset value. On the contrary the deviation of (t) from (V (t)) can be regarded as a reduced-form component, since it is governed by the parameters a and k, which are not rm-specic. Hence, from a physical standpoint, we can consider that the dynamics of the default intensity around its long-run mean incorporates the inter-temporal eects of all the external (not rm-specic) factors such as, for instance, the public policy, the business trend, or the macroeconomic environment. In other words, in the spirit of the true reduced-form approach, the intensity process (t) is introduced in order to take into account the probability of unexpected default due to not rm-specic variables. However, as is physically reasonable, the eect of such external factors is not assumed to be completely independent on the rms capital structure, but is related to the rms asset value through the long-run mean (V (t)). Equation (4) implies that when k = 0 and a + the intensity of default tends to be equal to its long-run mean (V (t)). Moreover from relation (6) follows that when b = 0 the function (V (t)) has the same form of the function used by Madan and Unal in [35] to model the dependence of the default intensity on the rms equity value (see formula (15) in [35]). In addition according to equation (2) when = 0 the rms asset value V (t) follows a driftless geometric Brownian motion, which is the same process used in [35] to describe the rms equity value. We conclude that when b = 0, = 0, k = 0 (c > 0), and in the limit a + the model proposed in this paper becomes mathematically identical to the model of Madan and Unal [35]. For analytical convenience the Wiener processes W (1) (t) and W (2) (t) are assumed to be uncorrelated. This assumption is not too restrictive since the parameters a, b, c, k, and the threshold level V already provide enough exibility, as shown by the numerical simulations carried out in Section 4. At this regard we also observe that the processes (t) and V (t) are not independent, since they are coupled through the function (V (t)). Let us consider the change of variables:

x(t) = logV (t) logV .

(7)

Using relation (7) and Itos lemma the equations (2), (3) can be respectively transformed as follows: dx(t) = dt + dW (1) (t),

(8)

x(t0 ) = x0 , where 6

(9)

2 , 2

(10)

x0 = logV0 logV . Moreover the equations (4), (5), (6) are respectively rewritten as follows: d(t) = a (t) (x(t)) dt + kdW (2) (t),

(11)

(12)

(t0 ) = 0 ,

(13)

(x(t)) = b +

c x2 (t)

(14)

In this paper, following the same approach used in [9], [10], [35], the threshold barrier V is considered as a self-adjustable parameter of the model. As a consequence x0 shall also be regarded as a model parameter, that can be obtained, for instance, by calibration to market data. Alternatively, in analogy with structural models, one could also assume that V is equal to the value of the rms outstanding debt. Finally, we observe that the initial datum x0 measures the distance to default of the rm issuing the bond at time t0 . In particular small values of x0 correspond to speculative-grade issuers while large values of x0 correspond to investment-grade issuers. The risk-free spot interest rate is denoted by r and is considered to be constant. This assumption is common to other models of credit risk (see for instance [6], [32], [33], [36]), and is made for analytical convenience. At this regard we briey mention that an analytically tractable model would also be obtained if the spot interest rate was described by a (tractable) stochastic dierential equation independent of the rms asset value. Such an approach is used for instance in [9], [10]. Let P (t, x, ) denote the price at time t of a corporate defaultable zero-coupon bond promising to pay 1 at time T > t. Moreover let Q(t) denote the price at time t of a default-free zero-coupon bond paying 1 at time T . Since the risk-free spot interest rate is assumed to be constant, we have:

Q(t) = er(T t) .

(15)

Following [9] we assume that in case of default the bond-holder receives defaultfree zero-coupon bonds paying 1 at time T (0 1). 7

Using standard arguments it can be shown that P (t, x, ) satises the partial dierential equation: P (t, x, ) c a b 2 t x P (t, x, ) 1 2 2 P (t, x, ) P (t, x, ) + k + 2 2 x (16)

1 2 P (t, x, ) + 2 + Q(t) P (t, x, ) rP (t, x, ) = 0, 2 x2 with nal condition:

P (T, x, ) = 1.

(17)

Moreover, due to the fact that default occurs with certainty when x(t) = 0, for t0 t < T the following boundary condition must be satised: P (t, 0, ) = Q(t). (18)

In order to uniquely determine the solution of the parabolic partial dierential equation (16) a boundary condition must be applied also for x +. From both the mathematical and the economic standpoint it is reasonable to require

P (t, x, ) nite as x +.

(19)

Moreover the fact that the default intensity is modeled using the Vasicek-type process (12) makes it unnecessary to impose boundary conditions at and at + (see [42]). We set:

= T t,

(20)

P (, x, ) = er H(, x, ).

(21)

Using relations (15), (20), (21), the equation (16), the nal condition (17), and the boundary conditions (18), (19) are respectively rewritten as follows: H(, x, ) c +a b 2 x H(, x, ) 1 2 2 H(, x, ) H(, x, ) k 2 2 x (22)

1 2 H(, x, ) 2 + H(, x, ) = 0, 2 x2 8

H(0, x, ) = 1,

(23)

H(, 0, ) = ,

(24)

H(, x, ) nite as x +. We guess a solution of the problem (22)-(25) of the form: H(, x, ) = + (1 )g(, x)eA( )+B( ) .

(25)

(26)

Substituting the expression (26) in equations (22), (23), (24), (25) and using separation of variable we obtain for B( ) the Cauchy problem: B( ) + aB( ) + 1 = 0,

(27)

B(0) = 0, for A( ) the Cauchy problem: 1 A( ) abB( ) k 2 B 2 ( ) = 0, 2

(28)

(29)

A(0) = 0, and for g(, x) the partial dierential equation: g(, x) g(, x) 1 2 2 g(, x) acB( ) g(, x) = 0, x 2 x2 x2 with initial condition:

(30)

(31)

g(0, x) = 1, and boundary conditions: 9

(32)

g(, 0) = 0.

(33)

g(, x) nite as x +.

(34)

The Cauchy problems (27)-(28) and (29)-(30) are typical of the Vasicek model (see [42]) and can be easily solved, so that we have: 1 1 ea , a

B( ) = 1 a2

(35)

A( ) =

1 2 k 2 B 2 ( ) k a2 b (B( ) + ) . 2 4a

(36)

Substituting (35) in (31) yields: g(, x) g(, x) 1 2 2 g(, x) c + 2 (1 ea )g(, x) = 0. 2 x 2 x x

(37)

The solution of the partial dierential equation (37) with initial condition (32) and boundary conditions (33), (34) cannot be obtained in closed-form, but must be computed by numerical approximation.

A closed-form approximate solution

In this section we derive a semi-explicit approximate solution of the partial dierential problem (37), (32), (33), (34). The method we use shares some similarities with that proposed in [5] to compute solutions of the model of Madan and Unal. The solution of (37), (32), (33), (34) is approximated using a power series expansion in the model parameter c with base point c = 0 truncated at rst-order: g(, x) = g0 (, x) + g1 (, x)c + O(c2 ), c 0.

(38)

Substituting (38) in (37), (32), (33), (34) and equating to zero the terms of the same order we obtain, for the zero-order term, the partial dierential equation: g0 (, x) g0 (, x) 1 2 2 g0 (, x) = 0, x 2 x2 with initial condition: 10

(39)

g0 (0, x) = 1, and boundary conditions:

(40)

g0 (, 0) = 0, g0 (, x) nite as x +, and, for the rst-order term, the partial dierential equation: g1 (, x) 1 2 2 g1 (, x) c g1 (, x) = 2 (1 ea )g0 (, x), 2 x 2 x x with initial condition:

(41)

(42)

g1 (0, x) = 0, and boundary conditions:

(43)

g1 (, 0) = 0, g1 (, x) nite as x +.

(44)

The zero-order coecient g0 (, x) can be obtained in closed-form. In fact the equations (39)-(41) constitute a standard parabolic problem with xed-barrier whose solution is given by (see [6], [38]):
2x

g0 (, x) = N(l1 ) e 2 N(l2 ), where + 2x , 2 2 2x , 2 2

y
z2

(45)

l1 =

(46)

l2 =

(47)

N(y) =

1 2

e 2 dz.

(48)

In order to compute the rst-order coecient of the power series expansion (38) let us consider the Laplace transforms of the functions g0 (, x) and g1 (, x) done with respect to the variable : 11

Fj (, x) =
0

gj (, x)e d, j = 0, 1.

(49)

From equations (39)-(44) we obtain, for the zero-order term, the dierential equation: 2 2 F0 (, x) 2 F0 (, x) 2 + 2 2 F0 (, x) = 2 , 2 x x with boundary conditions:

(50)

F0 (, 0) = 0, F0 (, x) nite as x +, and, for the rst-order term, the dierential equation: 2 F1 (, x) 2 F1 (, x) 2 2F0 (, x) 2F0 ( + a, x) + 2 2 F1 (, x) = , 2 x x 2 x2 2 x2 with boundary conditions:

(51)

(52)

F1 (, 0) = 0, F1 (, x) nite as x +.

(53)

The dierential problems (50)-(51) and (52)-(53) can be solved in closed-form. The dierential equations (50), (52) have the same characteristic equation: 2 + whose roots are 2 2 2 + 2, 4 + 2 2 2 + 2. 4 2 2 2 = 0, 2

(54)

1 =

2 =

(55)

The dierential problem (50)-(51) has the following solutions: 1 (1 e1 x ).

F0 (, x) = Substituting (56) in (52) we obtain:

(56)

2 F1 (, x) 2 F1 (, x) 2 + 2 2 F1 (, x) = m(x), x2 x 12

(57)

where 2 2 1 e1 x 1 e1 x , 2 x2 2 x2 ( + a)

m(x) = and

(58)

1 =

2 2( + a) + . 4 2

(59)

The solution of the dierential equation (57) with boundary conditions (53) can be found using the method of variations of parameters: 1 1 (H1 (x) H2 (x)) e1 x + H2 (x)e2 x , 1 2 1 2

F1 (, x) = where

(60)

H1 (x) =
0

m(v) e1 v e2 v dv,
+

(61)

H2 (x) =
x

m(v)e2 v dv.

(62)

Explicit analytical expressions for H1 (x) and H2 (x) are derived in Appendix A. Now in order to obtain g1 (, x) it remains to invert the Laplace transform F1 (, x). A very fast and reliable method to solve this problem is the well-known algorithm of Gaver-Stehfest [21], [41]: log 2 g1 (, x)= where M is an even integer,
min(j, M ) 2 M

j F1
j=1

log 2 j, x ,

(63)

j = (1)(

M 2

+1)

l( 2 +1) (2l)!
M

l=[

j+1 2

M l !l!(j l)!(2l 1)! 2

(64)

and [] denotes the integer part of . It is usually optimal to choose 8 M 12. The numerical simulations presented in the next section are carried out using M = 8. So far the solution of the partial dierential problem (37), (32), (33), (34) can be approximated using the asymptotic expansion (38) truncated at rst-order. 13

Numerical results

For the sake of clarity this section is divided in two parts: in Subsection 4.1 we test the validity of the model, in Subsection 4.2 we test the computational eciency of the closed-form approximate solution derived in Section 3.

4.1

Model validation

We consider three dierent test-cases: Test Case 1 and Test Case 2, where we test the performance of the model in describing credit spreads for speculative-grade and investment-grade bonds respectively; Test Case 3 where the model parameters are calibrated to market data. We recall that the credit spread at time t = t0 is dened as follows: P (t0 , x0 , 0 ) 1 log . T t0 Q(t0 )

CreditSpread =

(65)

Using relations (15), (20), (21), (26) the above formula can be rewritten as follows: 1 log + (1 )g(T t0 , x0 )eA(T t0 )+B(T t0 )0 . T t0

CreditSpread =

(66)

The function g(x, T t0 ) is evaluated using the closed-form approximate solution derived in Section 3, that is, instead of (66), we compute: 1 log + (1 ) (g0 (T t0 , x0 ) + g1 (T t0 , x0 )c) T t0 eA(T t0 )+B(T t0 )0 .

CreditSpread =

(67)

In all the experiments concerning Test Case 1 and Test Case 2 the model parameters , and are set to xed values. On the contrary the parameters of the equations (12)-(14) are varied in order to study their inuence on credit spreads. TEST CASE 1: to test the capability of the model to describe term structures of speculative-grade bonds let us set x0 = 0.75 and let us consider maturities T t0 ranging from one year up to 30 years. In our study the parameters , and are xed as follows: = 0.08 year 1, = 0.4 year 1/2, = 0.5. On the contrary we have chosen a set of starting values 14

for 0 , a, b, c, k, from which we vary one of these parameters at the time with the others set at the corresponding starting values to test the credit spreads. First of all we present the tests where 0 , b, c, k are varied. In these experiments the starting values are chosen as follows: 0 = 0.002 year 1, a = 1.0 year 1, b = 0.0005 year 1, c = 0.001 year 1, k = 0.02 year 1/2. All the conclusions and observations about the qualitative eect of the parameters 0 , b, c, k are supported by many other numerical simulations (not included in the paper) where we have used starting values (for 0 , a, b, c, k) and xed values (for , , ) dierent from those specied above. In other words the observed qualitative eect of the parameters 0 , b, c, k does not depend on the particular choice of xed values and starting values made in this paper. Other kinds of considerations will be done later about the eect of varying the parameter a. Initial default intensity 0 . The results obtained are shown in Figure 1. As it is reasonable to expect, when 0 increases, the credit spreads also increase, especially for short maturities. It is interesting to observe that the shape of the credit spread curve varies depending on the initial default intensity. In particular when 0 is small the term structure is upward sloping for short maturities and downward sloping for longer maturities. Instead when 0 is large the term structure is everywhere downward sloping. Note that previous empirical works (see [19], [39]) report that the term structure of speculative-grade bonds is downward sloping for both short and long maturities. Hence our model highlights that the value of the initial default intensity is fundamental in order to reproduce the shape of the credit spread curve correctly for short maturities. Parameter b. The results obtained are shown in Figure 2. We may note that when b increases, the credit spreads also increase. This is not surprising since the long-run mean of the default intensity is directly proportional to the parameter b. Parameter c. In Figure 3 we may note that when c increases, the credit spreads also increase. Again this is due to the fact that the long-run mean of the default intensity is directly proportional to the parameter c. It is interesting to observe that the eect of variations of the parameter c is greater for maturities close to the maturity at which the term structure has its maximum peak. Parameter k. As shown in Figure 4 the credit spreads decrease when k increases. This fact can be explained as follows: according to relation (66) the credit spreads depend on k only through the quantity A(T t0 ). Now when k increases A(T t0 ) increases (since its derivative done with respect to T t increases, see equation (29)), and, as a consequence, the credit spreads also decrease.

15

0.12

0.1

0 = 0.002 year1 = 0.03 year1 0 0 = 0.25 year1

0.08 CreditSpread*

0.06

0.04

0.02

10

15 Tt (year)
0

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, a = 1.0 year 1 , b = 0.0005 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 1: Eect of 0 on credit spreads, x = 0.75.

0.06

0.05

b = 0.0005 year1 1 b = 0.005 year b = 0.01 year1

0.04 CreditSpread*

0.03

0.02

0.01

10

15 Tt (year)
0

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , a = 1.0 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 2: Eect of b on credit spreads, x = 0.75.

16

0.06

0.05

c = 0.001 year1 c = 0.005 year1 1 c = 0.01 year

0.04 CreditSpread*

0.03

0.02

0.01

10

15 Tt (year)
0

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , a = 1.0 year 1 , b = 0.0005 year 1 , k = 0.02 year 1/2

Figure 3: Eect of c on credit spreads, x = 0.75.

0.06

0.05

k = 0.02 year1/2 k = 0.1 year1/2 1/2 k = 0.2 year

0.04 CreditSpread*

0.03

0.02

0.01

10

15 Tt (year)
0

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , a = 1.0 year 1 , b = 0.0005 year 1 , c = 0.001 year 1

Figure 4: Eect of k on credit spreads, x = 0.75.

A special attention must be paid to the rate of mean reversion a, since its qualitative eect on the term structure is dierent depending on the particular choice of the parameters b, c, 0 . In fact if we set 0 = 0.002 year 1, b = 0.0005 year 1, c = 0.001 year 1, k = 0.02 year 1/2, then we nd that when a increases, the credit spreads also increase, especially for long maturities (see Figure 5). Instead if we 17

set 0 = 0.25 year 1, b = 0.0005 year 1, c = 0.001 year 1, k = 0.02 year 1/2, when a increases, the credit spreads decrease, especially for short maturities (see Figure 6). This fact can be explained as follows: in the case shown in Figure 5 the default intensity (t) is, at least at the initial times, smaller than its long-run mean (x(t)). Now the default intensity (t) reverts to its long-run mean faster as the rate of mean reversion a increases. As a consequence the rm is more likely to default as the parameter a increases. On the contrary in the case shown in Figure 6 the default intensity is, at least at the initial times, greater than its long-run mean. Therefore the probability of default tends to decrease as the parameter a increases. Analogous behaviour has been observed also for values of b, c, 0 , k other from those cited above.
0.06

0.05

a = 1.0 year1 a = 0.1 year1 1 a = 0.05 year

0.04 CreditSpread*

0.03

0.02

0.01

10

15 Tt (year)
0

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , b = 0.0005 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 5: Eect of a on credit spreads, x = 0.75.

18

0.12

0.1

a = 1.5 year1 1 a = 1.0 year a = 0.75 year1

0.08 Credit spread*

0.06

0.04

0.02

10

15 Tt (year)
0

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.25 year 1 , b = 0.0005 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 6: Eect of a on credit spreads, x = 0.75.

TEST CASE 2: to test the capability of the model to describe term structures of investment-grade bonds let us set x0 = 1.5 and let us consider maturities T t0 ranging from one year up 30 years. As done in Test Case 1: we set , , at xed values = 0.08 year 1, = 0.4 year 1/2, = 0.5. Moreover as far as the parameters 0 , a, b, c, k are concerned, a set of starting values is chosen from which these parameters are varied one by one. First of all we present the results concerning the eect of the parameters 0 , b, c, k. In these experiments the starting values are chosen as follows: 0 = 0.002 year 1, a = 1.0 year 1, b = 0.0005 year 1, c = 0.001 year 1, k = 0.02 year 1/2 . Several other numerical simulations (not included in the paper) reveal that, as already experienced in Test Case 1, the qualitative eect of the parameters 0 , b, c, k is not inuenced by the particular choice of xed values and starting values. Initial default intensity 0 . The results obtained are shown in Figure 7. As experienced in Test Case 1, also in Test Case 2 the shape of the term structure is strongly aected by the initial default intensity. In fact when 0 is large the term structure is downward sloping. On the contrary when 0 is small the term structure is signicantly upward sloping for short maturities and slightly downward sloping for long maturities. Therefore the results obtained using small values of 0 are consistent with the empirical works [19], [39], that indicate that the term structure of investment-grade bonds is, for short maturities, upward sloping, and rather at for longer maturities. 19

It is interesting to note in Figure 7 that for intermediate values of 0 (around 0.05 year 1 ) the yield spread curve is double humped. This fact has an interesting explanation. First of all, looking at the curves reported in Figure 7, we observe that the initial branch of the term structure is strongly inuenced by the initial default intensity, which reects the probability of unexpected default due to not rm-specic factors (for instance bad macroeconomic conditions). Therefore the initial branch of the term structure (maturities shorter than about 3 year) can be considered as not rm-specic. Instead the nal branch of the term structure (maturities longer than about 10 year) is only moderately aected by the initial default intensity, and can be considered as rm-specic. In fact, for long maturities, the default intensity tends to revert to its long-run mean, which only depends on the structural variable V (t), and, in addition, the probability that the rms asset value falls below the default threshold level starts to become signicant. In this respect the rm-specic branch of the term structure is downward sloping, as pure structural models always predict (see for example [6], [36]). Now let us focus our attention on the double humped curve reported in Figure 7: the initial branch of this curve (not rm-specic) is downward sloping since, as maturities increase (from zero up to about 3 year) the probability of unexpected default decreases (recall that the intensity of default is modeled as a mean-reverting process), and consequently credit spreads decrease. So far, since 0 is not very large, the not rm-specic branch (maturities shorter than about 3 year) turns out to be lower than the rm-specic branch (maturities longer than about 10 year), so that the matching between the two branches gives rise to a double spike. Therefore double humped curves reect the complex interaction between probability of unexpected default due to not rm-specic factors and structural information. We observe that double humped term-structures were not experienced in Test Case 1. This is consistent with the above explanation. In fact, in the case of speculative-grade bonds, the function (x(t)) is considerably large, at least at the initial times (since x0 is small). Therefore, for intermediate values of 0 , the intensity of default, which is mean-reverting to (x(t)), tends, at the initial times, to increase. As a consequence, for intermediate values of 0 , the initial branch of the yield spread curve is upward sloping (see Figure 1), and the double spike does not occur. Parameter b. As we may note in Figure 8 the eect of the parameter b on the term structure is analogous to that experienced in Test Case 1: when b increases the credit spreads increase. Parameter c. The results obtained are analogous to those obtained in Test Case 1 and are shown in Figure 9: when c increases, the credit spreads also increase. Moreover the eect of variations of the parameter c is particularly evident for maturities close to the maturity at which the credit spread curve has its maximum. Parameter k. The results obtained are shown in Figure 10: when k increases the credit spreads decrease. As already observed in Test Case 1, the eect of the parameter k can be easily understood from relations (29), (66).

20

By comparison of Figure 8, Figure 9, Figure 10 with Figure 1, Figure 2, Figure 3 we clearly note that the maturity at which the credit spread curve has its maximum peak is greater for investment-grade bonds (approximately 10 year) than for speculative-grade bonds (approximately 2 year). Moreover the value of the maximum is greater for investment-grade bonds than for speculative-grade bonds, as it is reasonable to expect.
0 = 0.002 year 1 0 = 0.05 year 1 = 0.1 year
0 1

0.03

0.025

CreditSpread*

0.02

0.015

0.01

0.005

10

15 Tt0 (year)

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, a = 1.0 year 1 , b = 0.0005 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 7: Eect of 0 on credit spreads, x = 1.5.

0.014

0.012

0.01 CreditSpread*

0.008

0.006

0.004

0.002

b = 0.0005 year1 b = 0.0015 year1 b = 0.003 year1

5 10 15 Tt0 (year) 20 25 30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , a = 1.0 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 8: Eect of b on credit spreads, x = 1.5.

21

0.016

0.014

0.012

CreditSpread*

0.01

0.008

0.006

0.004

0.002

c = 0.001 year1 c = 0.005 year1 c = 0.01 year1

5 10 15 Tt0 (year) 20 25 30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , a = 1.0 year 1 , b = 0.0005 year 1 , k = 0.02 year 1/2

Figure 9: Eect of c on credit spreads, x = 1.5.

0.014

0.012

0.01

CreditSpread*

0.008

0.006

0.004

0.002

k = 0.02 year1/2 k = 0.5 year1/2 k = 0.75 year1/2

5 10 15 Tt0 (year) 20 25 30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , a = 1.0 year 1 , b = 0.0005 year 1 , c = 0.001 year 1

Figure 10: Eect of k on credit spreads, x = 1.5.

As already experienced in Test Case 1, the qualitative eect of the parameter a on the term structure is dierent depending on the choice of the parameters b, c, 0 . In fact, in the case shown in Figure 11, where 0 = 0.002 year 1, the default intensity is, at least at the initial times, smaller than its long-run mean. As a consequence when a increases the credit spreads also increase. This eect is 22

particularly evident for long maturities. On the contrary, in the case shown in Figure 12, where 0 = 0.05 year 1, the default intensity is, at least at the initial times, greater than its long-run mean, so, when a increases the credit spreads decrease (especially for short maturities). Again we may note that, unlike what happens in Test Case 1, for intermediate values of 0 (around 0.05 year 1) the term structures obtained are double humped.
0.014

0.012

0.01

CreditSpread*

0.008

0.006

0.004

0.002

a = 1.0 year1 a = 0.2 year1 a = 0.1 year1

5 10 15 Tt0 (year) 20 25 30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.002 year 1 , b = 0.0005 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 11: Eect of a on credit spreads, x = 1.5.

0.02

0.018

a = 1.0 year 1 a = 0.75 year a = 0.5 year1

0.016 Credit spread*

0.014

0.012

0.01

10

15 Tt0 (year)

20

25

30

= 0.08 year 1 , = 0.4 year 1/2 , = 0.5, 0 = 0.05 year 1 , b = 0.0005 year 1 , c = 0.001 year 1 , k = 0.02 year 1/2

Figure 12: Eect of a on credit spreads, x = 1.5.

23

Summary. From the results obtained we conclude that: the datum 0 , that represents the initial condition of the stochastic dierential equation (4), strongly aects the shape of the term structure, which can be strictly downward sloping, humped, or, in the case of investment-grade bonds, even double humped. Moreover when 0 , b, c increase the credit spreads also increase, while when k increases the credit spreads decrease. A dierent eect has been observed concerning the parameter a: when a increases the credit spreads increase if the initial default intensity 0 is smaller than the long-run mean (x0 ), and decrease if the initial default intensity 0 is greater than the long-run mean (x0 ). Finally the maturity at which the term structure has its maximum peak is greater for investment-grade bonds (approximately 10 year) than for speculative-grade bonds (approximately 2 year). TEST CASE 3: in this test case we calibrate model parameters to market data. In particular we set = 0.08 year 1, = 0.4 year 1/2, = 0.5, and we estimate a, b, c, k, and the initial data x0 , 0 from realized credit spreads. The set of data used consists of the credit spreads of AA-rated bonds obtained in the empirical study [39], which is often used in the literature for test and comparison purposes (see for instance [13], [23], [33]). For the readers convenience these data are reported in Table 1. T t0 (year) credit spread 1.5 0.00621 3.5 0.00562 5.5 0.00620 7.5 0.00620 9.5 0.00575 11.5 0.00566 Table 1: Credit spreads of AA-rated bonds reported by [39]. The parameters a, b, c, k, and the initial data x0 , 0 are determined by leastsquare tting of the credit spreads shown in Table 1 to the approximate formula (67). We have obtained: a = 0.305 year 1, b = 0.00015 year 1, c = 0.00125 year 1, k = 0.06333 year 1/2, x0 = 1.75, 0 = 0.0158 year 1. Finally we have calculated (using formula (67)) the term structure that corresponds to the above set of parameters and initial data. The curve obtained is shown in Figure 13, along with the empirical credit spreads used for the calibration. We may note the excellent agreement between the theoretical curve and the empirical data. In particular the double humped term structure predicted by our model appears to be crucial in order to properly t the observed credit spreads.

24

x 10

empirical data our model

CreditSpread

10

15 Tt0 (year)

20

25

30

Figure 13: Eect of 0 on credit spreads.

4.2

Testing the closed-form approximate solution

In order to test the accuracy of the closed-form approximate solution derived in Section 3, let us compute the bond price P (t0 , x0 , 0 ) using the closed-form approximation obtained in Section 3: P (t0 , x0 , 0 ) = er(T t0 ) ( + (1 )g0 (T t0 , x0 ) + g1 (T t0 , x0 )c) eA(T t0 )+B(T t0 )0 , and let us dene the relative numerical error on the bond price as follows: P (t0 , x0 , 0 ) P (t0 , x0 , 0 ) . P (t0 , x0 , 0 ) (68)

ErrP (t0 , x0 , 0 ) =

(69)

Instead the relative numerical error on the credit spread is dened as follows: CreditSpread (t0 , x0 , 0 ) CreditSpread(t0 , x0 , 0 ) . ErrCS (t0 , x0 , 0 ) = CreditSpread(t0 , x0 , 0 )

(70)

In order to evaluate the above two quantities a fairly accurate estimation of g(t0 , x0 ) is obtained by nite dierence approximation of the partial dierential equation (37). In particular we have employed the Crank-Nicholson nite dierence scheme on a (uniform) mesh of 800 grid points in the xdirection and 5000 grid points in the direction. 25

Note that all the numerical simulations carried out so far are performed again using the nite dierence approximation, that is ErrP (t0 , x0 , 0 ) and ErrCS (t0 , x0 , 0 ) are evaluated for every combination of parameters a, b, c, k and data x0 , 0 , T t0 considered in Test Case 1, Test Case 2 and for the set of parameters estimated in Test Case 3. We have obtained the following results: ErrP (t0 , x0 , 0 ) in Test Case 1 is always smaller than 0.0081, in Test Case 2 is always smaller than 0.0059 and in Test Case 3 is always smaller than 0.00016. Moreover ErrCS (t0 , x0 , 0 ) in Test Case 1 is always smaller than 0.017, in Test Case 2 is always smaller than 0.035 and in Test Case 3 is always smaller than 0.0037. In addition the largest relative errors on credit spreads are experienced for short maturities, which can be explained as follows: when T t0 is small P (t0 , x0 , 0 ) is close to 1, hence, due to relation (65), the denominator of (70) is close to zero, and the relative error on the credit spread is large. Finally we mention that ErrP (t0 , x0 , 0 ) and ErrCS (t0 , x0 , 0 ) are often of order 104 , 105 , and sometimes also of order 106 . Such a level of accuracy is substantially greater than the level of accuracy that is normally required in everyday business practice. The numerical simulations presented in this paper are carried out on a computer with a Pentium 4 Processor 1700 MHZ 256 MB Ram and the software programs are written using FORTRAN 77. The computer time necessary to evaluate (one time) the credit spread of a defaultable bond using relation (67) is approximately 0.16 millisecond. This time is extremely small, hence, from the computational standpoint, the closed-form approximate solution derived in Section 3 is particularly ecient.

Conclusions

A new model to price defaultable bonds is proposed which combines structural information with the reduced-form approach. The main novelty of the model is that the default intensity is described using a stochastic dierential equation coupled with the process of the rms asset value. Such an approach allows to incorporate structural information as well as to capture the complex dynamics of unexpected default due to not rm-specic variables. From the practical standpoint, the model oers great exibility to describe credit spreads and allows to correctly reproduce important stylized facts. In particular, in according to previous empirical ndings ([19], [39]), it is possible to have, for speculative-grade bonds, downward sloping term structures and, for investmentgrade bonds, term structures that are signicantly upward sloping for short maturities and rather at for longer maturities. In addition double humped term structures can also be obtained, which reects the complex interaction between structural information and probability of unexpected default, and reveals to be crucial in order to properly t realized market data. Term structures with multiple peaks are sometimes experienced in the nancial markets (see [7], [18], [22], [37], [39]), but are not

26

observed in [9], [10], [35], presumably because in these models the interaction between structural information and probability of unexpected default is too simplied. It is also worth noticing that when the parameters used to dene the drift of the default intensity process converge to appropriate values the model proposed in this paper recovers the model of Madan and Unal [35] as a limit case. Finally our model is also mathematically tractable, as a closed-form approximate solution can be obtained using a perturbation approach in conjunction with the Laplace transform. This formula is accurate and computationally ecient, and is employed in this paper to estimate model parameters by least-square tting of realized market data. However it could also be used to evaluate the derivatives of the bond price done with respect to the initial data or to model parameters (the Greeks). Finally the approximate closed-form solution derived in Section 3 is well-suited for parallel computing, since the numerical algorithm used to invert the Laplace transform is fully parallelizable.

27

References
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[15] Due D., Singleton K., Modeling Term Structures of Defaultable Bonds, Review of Financial Studies 12 (1999) 687-720. [16] Due D., Singleton K., Credit Risk: Pricing, Measurement, and Management, Princeton University Press, Princeton, N.J. (2003). [17] Elliott R.J., Jeanblanc M., Yor M., On Models of Default Risk, Mathematical Finance 10 (2000) 179-196. [18] Eom H.Y., Helwege J., Huang J.Z., Structural Models of Corporate Bond Pricing: an Empirical Analysis, Review of Financial Studies 17 (2004) 499-544. [19] Fons J.S., Using Default Rates to Model the Term Structure of Credit Risk, Financial Analysts Journal (1994, September/October) 25-32. [20] Fouque J.P., Sircar R., Slna K., Stochastic Volatility Eects on Defaultable Bonds, Applied Mathematical Finance 13 (2006) 215-244. [21] Gaver D.P., Observing Stochastic Processes and Approximate Transform Inversion, Operations Research, 14 (1966) 444-459. [22] Houweling P., Hoek J., Kleibergen F., The Joint Estimation of Term Structures and Credit Spreads, Journal of Empirical Finance 8 (2001) 297-323. [23] Hsu J.C., Saa-Requejo J., Santa-Clara P., Bond Pricing with Default Risk, Working Paper, UCLA Anderson School of Management (2004), available at http : //papers.ssrn.com/sol3/papers.cf m?abstract id = 611401. [24] Kijima M., Valuation of a Credit Swap of the Basket Type, Review of Derivatives Research, 4 (2000) 81-97. [25] Kijima M., Muromachi Y., Credit Events and the Valuation of Credit Derivatives of Basket Type, Review of Derivatives Research, 4 (2000) 55-79. [26] Jacobs K., Li X., Modeling the Dynamics of Credit Spreads with Stochastic Volatility, Journal of Derivatives 11 (2003) 30-44. [27] Jarrow R.A., Default Parameter Estimation Using Market Prices, Financial Analysts Journal 57 (2001) 75-92. [28] Jarrow R.A., Lando D., Yu F., Default Risk and Diversication: Theory and Empirical Implications, Mathematical Finance 15 (2005) 1-26. [29] Jarrow R.A., Stuart M.T., Pricing Derivatives on Financial Securities subject to Credit Risk, Journal of Finance 50 (1995) 53-85.

29

[30] Jones E., Mason S., Roseneld E., Contingent Claim Analysis of Corporate Capital Structure: an Empirical Investigation, Journal of Finance 39 (1984) 611-627. [31] Lando D., On Cox Processes and Credit Risky Securities, Review of Derivatives Research 2 (1999) 99-120. [32] Leland H.E., Predictions of Default Probabilities in Structural Models of Debt, Journal of Investment Management 2 (2004), available at www.haas.berkeley.edu/f aculty/pdf /LelandP aperJOIM 4.pdf . [33] Leland H.E., Toft K.B., Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads, Journal of Finance 51 (1996) 9871019. [34] Longsta F.A., Schwartz E.S., A Simple Approach to Valuing Risky Fixed and Floating Rate Debt, Journal of Finance 50 (1995) 789-819. [35] Madan D., Unal H., Pricing the Risk of Default, Review of Derivatives Research 2 (1998) 121-160. [36] Merton R.C., On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance 29 (1974) 449-470. [37] Nelson C.R., Seigel A.F., Parsimonious Modeling of Yield Curves, Journal of Business 60 (1987) 473-489. [38] Rich D.R., The Mathematical Foundations of Barrier Option Pricing Theory, Advances in Futures and Options Research 7 (1994) 267-311. [39] Sarig O., Warga A., Some Empirical Estimates of the Risk Structure of Interest Rates, Journal of Finance 44 (1989) 1351-1360. [40] Schnbucher P.J., A Tree Implementation of a Credit Spread Model for Credit o Derivatives, Journal of Computational Finance 6 (2002) 1-38. [41] Stehfest H., Algorithm 368: Numerical Inversion of Laplace Transforms, Communications of the ACM 13 (1970) 47-49 (erratum 624). [42] Vasicek O.A., An Equilibrium Characterization of the Term Structure, Journal of Financial Economics 15 (1977) 177-188. [43] Zhou C.S., The Term Structure of Credit Spreads with Jump Risk, Journal of Banking and Finance 25 (2001) 2015-2040.

30

Appendix A: calculation of H1(x) and H2(x)

Substituting (58) in (61), (62) we obtain: 2 2 2 2
x 0 x 0

H1 (x) =

e1 v e2 v + e(1 2 )v 1 dv v 2 e1 v e2 v + e(1 2 )v e(1 1 )v dv, ( + a)v 2 (A-1)

2 H2 (x) = 2

+ x

e2 v e(1 2 )v 2 dv 2 v 2

+ x

e2 v e(1 2 )v dv. ( + a)v 2

(A-2)

The integrals H1 (x) and H2 (x) can be evaluated using an explicit formula. In fact we have (see [1]): elx elx dx = lEi(lx) + K, K C, l C \ {0}, x2 x

(A-3)

where Ei denotes the so-called exponential integral function, dened as follows:

+

Ei(z) = + log(z) +
j=1

zj , z C \ {0}, jj!

(A-4)

where denotes the Euler-Mascheroni constant. Note that the following extension of the logarithm function from the real positive semi-axis to the complex plane is considered in this paper: log |z| + arg(z)i, z C \ {0}, arg(z) ,

log(z) =

log |z| + arg(z)i 2i, z C \ {0}, arg(z) > ,

(A-5)

where i denotes the imaginary unit and arg(z) is the complex argument of z. It is important to observe that the exponential integral function (A-4) can be evaluated very quickly with essentially no error using standard numerical algorithms (see [2]). Using relation (A-3) and some rather tedious algebra H1 (x) and H2 (x) are evaluated as follows:

31

H1 (x) =

1 e1 x + e2 x e(1 2 )x 2 1 e1 (x) + (1 2 )e3 (x) 2 x

+ 2 e2 (x) + 1 log(1 ) 2 log(2 ) (1 2 )log(1 2 ) + 1 log(1 ) 2 e1 x + e2 x + e(1 1 )x e(1 2 )x 1 e1 (x) + 2 e2 (x) 2 ( + a) x (1 1 )e4 (x) + (1 2 )e5 (x) + 1 log(1 ) 2 log(2 ) + (1 1 )log(1 1 ) (1 2 )log(1 2 ) , (A-6)

H2 (x) =

2 e2 x e(1 2 )x + 2 e2 (x) + (1 2 )e3 (x) 2 x 2 e2 x e(1 2 )x 2 ( + a) x (A-7)

2 q(2 ) (1 2 )q(1 2 )

+2 e2 (x) + (1 2 )e5 (x) 2 q(2 ) (1 2 )q(1 2 ) , where

e1 (x) = Ei(1 x),

(A-8)

e2 (x) = Ei(2 x),

(A-9)

e3 (x) = Ei((1 2 )x),

(A-10)

e4 (x) = Ei((1 1 )x),

(A-11)

e5 (x) = Ei((1 2 )x), 32

(A-12)

and , l C, (l) > 0,

q(l) =

, l C, (l) 0,

(A-13)

where (l) denotes the imaginary part of l. Note that in order to calculate H2 (x) we have used the fact that

lim Ei(lx) = q(l), l C \ {0}, (l) 0,

(A-14)

where (l) denotes the real part of l.

Appendix B: Modeling (t) by a generalized CIR square root process

We consider an extension of the model proposed in Section 2 where the intensity of default follows a generalized CIR square root process, and show that also in this case a closed-form approximate solution can be obtained. The CIR square root process is described by the following stochastic dierential equation:

dY (t) = a (Y (t) ) dt + k

Y (t)dW (t).

(B-1)

It can be shown that the process (B-1) cannot take negative values, and remains 2a strictly positive if the condition 2 > 1 is satised. k Let us consider the model proposed in Section 2 and assume that the intensity of default follows, instead of the generalized Vasicek process (12), the generalized CIR square root process: (t)dW (2) (t),

d(t) = a (t) (x(t)) dt + k

(B-2)

(t0 ) = 0 , where c x2 (t)

(B-3)

(x(t)) = b + 33

(B-4)

Following standard arguments and using a notation analogous to that employed in Section 2 we obtain that the price of a zero-coupon bond PCIR (t, x, ) must satisfy the partial dierential problem: c PCIR (t, x, ) a b 2 t x + PCIR (t, x, ) 1 2 2 PCIR (t, x, ) + k 2 2

PCIR (t, x, ) 1 2 2 PCIR (t, x, ) + x 2 x2 +Q(t) PCIR (t, x, ) rPCIR (t, x, ) = 0,

(B-5)

PCIR (T, x, ) = 1,

(B-6)

PCIR (t, 0, ) = Q(t), As done in Section 3 we set

PCIR (t, x, ) nite as x +.

(B-7)

= T t,

(B-8)

PCIR (, x, ) = er HCIR (, x, ), and look for a solution of (B-5)-(B-7) of the form

(B-9)

HCIR (, x, ) = + (1 )gCIR (, x)eACIR ( )+BCIR ( ) .

(B-10)

By substituting (B-10) in (B-5)-(B-7) we obtain for ACIR ( ) and BCIR ( ) two ordinary dierential equations that can be solved expicitly (the details are left to the reader): 2ab ACIR ( ) = 2 log k 2de 2 (d a) (ed 1) + 2d
(da)

(B-11)

2 ed 1 BCIR ( ) = , (d a) (ed 1) + 2d where 34

(B-12)

d=

a2 + k 2 .

(B-13)

The coecients (B-11) and (B-12) are typical of the CIR model (see [12]). The function gCIR (, x) must satisfy the partial dierential problem: gCIR (, x) 1 2 2 gCIR (, x) acBCIR ( ) gCIR (, x) gCIR (, x) = 0, x 2 x2 x2 (B-14)

gCIR (0, x) = 1,

(B-15)

gCIR (, 0) = 0,

gCIR (, x) nite as x +.

(B-16)

In order to approximate gCIR (, x) let us consider the following truncated powerseries expansion in the model parameter c: gCIR (, x) = g0 (, x) + g 1,CIR (, x)c + O(c2 ),

c 0.

(B-17)

Moreover let us consider the following truncated power-series expansion of g 1,CIR in the parameter k 2 : g 1,CIR (, x) = g1,CIR (, x) + O(k 2 ), k 0. Combining (B-17) and (B-18) we approximate gCIR (, x) as follows: gCIR (, x) = g0 (, x) + g1,CIR (, x)c + O(ck 2 ) + O(c2),

(B-18)

c 0, k 0. (B-19)

Note that the expansion in the parameter k is done since, in order to obtain a closed-form solution, we shall take advantage of the fact that ed 1 + O(k 2 ), d

BCIR ( ) =

k 0,

(B-20)

as can be immediately inferred from (B-12), (B-13). The expansion in the parameter k around k = 0 is justied by the fact that when the process (B-1) is used to describe the default intensity in reduced-form models the parameter k is typically of order 102 or 101 (see for instance [14], [28]), while the parameter c is of order 103 or 35

102 (see Section 4). Therefore, with respect to g0 (, x)+g1,CIR (, x)c, O(ck 2 ) terms in (B-19) are negligible. Moreover we note that the true diusive contribution of the volatility parameter k is already taken into account by the presence in (B-10) of the factor eACIR ( )+BCIR ( ) that multiplies gCIR (, x) in (B-10). Note that the zero-order coecient g0 (, x) of the power-series expansion (B-19) is already set equal to the zero-order coecient of the power-series expansion (38). In fact the partial dierential problem (B-14)-(B-16) is, at zero-order, identical to the partial dierential problem (31)-(34). Substituting (B-19) in (B-14)-(B-16), using (B-20), and equating the rst-order terms, we obtain the partial dierential problem: g1,CIR (, x) 1 2 2 g1,CIR (, x) ac g1,CIR (, x) = 2 (1 ea )g0 (, x), x 2 x2 dx (B-21)

g1,CIR (0, x) = 0,

(B-22)

g1,CIR (, 0) = 0, g1,CIR (, x) nite as x +. Following the same approach used in Section 3 the Laplace transform
+

(B-23)

F1,CIR (, x) =
0

g1,CIR (, x)e d

(B-24)

can easily be obtained in closed-form. In particular, due to the strong similarity between equation (B-21) and equation (42) the method to used to calculate F1,CIR (, x) is identical to the method used in Section 3 to calculate F1,CIR (, x) Therefore the details of the calculation of F1,CIR (, x) are omitted and only the nal result is given: 1 1 (H1,CIR (x) H2,CIR (x)) e1 x + H2,CIR (x)e2 x , 1 2 1 2 (B-25)

F1,CIR (, x) =

where

36

H1,CIR (x) =

2 1 e1 x + e2 x e(1 2 )x 1 e1 (x) + (1 2 )e3 (x) 2 x

+ 2 e2 (x) + 1 log(1 ) 2 log(2 ) (1 2 )log(1 2 ) + 1 log(1 ) e1 x + e2 x + e(1,CIR 1 )x e(1,CIR 2 )x 2 1 e1 (x) + 2 e2 (x) 2 ( + d) x

(1,CIR 1 )e4,CIR (x) + (1,CIR 2 )e5,CIR (x) + 1 log(1 ) 2 log(2 ) + (1,CIR 1 )log(1,CIR 1 ) (1,CIR 2 )log(1,CIR 2 ) , (B-26)

H2,CIR (x) =

e2 x e(1 2 )x 2 + 2 e2 (x) + (1 2 )e3 (x) 2 q(2 ) 2 x 2 e2 x e(1,CIR 2 )x + 2 e2 (x) 2 ( + a) x

(1 2 )q(1 2 )

+(1,CIR 2 )e5,CIR (x) 2 q(2 ) (1,CIR 2 )q(1,CIR 2 ) , (B-27)

1,CIR =

2 2( + d) + , 4 2

(B-28)

e4,CIR (x) = Ei((1,CIR 1 )x),

(B-29)

e5,CIR (x) = Ei((1,CIR 2 )x),

(B-30)

1 and 2 are given by (55), e1 (x), e2 (x), e3 (x) are given by (A-8), (A-9), (A-10), respectively, and q() is given by (A-13).

37