Pricing credit default swaps under a multi-scale stochastic volatility model

In this paper, we consider the pricing of credit default swaps (CDSs) with the reference asset driven by a geometric Brownian motion with a multi-scale stochastic volatility (SV), which is a two-factor volatility process with one factor controlling the fast time scale and the other representing the...

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Bibliographic Details
Published in:Physica A 2017-02, Vol.468, p.425-433
Main Authors: Chen, Wenting, He, Xinjiang
Format: Article
Language:English
Subjects:
Credit default swaps
Down-and-out binary option
Multi-scale
Perturbation method
Stochastic volatility
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Summary:In this paper, we consider the pricing of credit default swaps (CDSs) with the reference asset driven by a geometric Brownian motion with a multi-scale stochastic volatility (SV), which is a two-factor volatility process with one factor controlling the fast time scale and the other representing the slow time scale. A key feature of the current methodology is to establish an equivalence relationship between the CDS and the down-and-out binary option through the discussion of “no default” probability, while balancing the two SV processes with the perturbation method. An approximate but closed-form pricing formula for the CDS contract is finally obtained, whose accuracy is in the order of O(ϵ+δ+ϵδ).
ISSN:0378-4371
1873-2119
DOI:10.1016/j.physa.2016.10.082