Pricing credit-risky bonds and spread options modelling credit-spread term structures with two-dimensional Markov-modulated jump-diffusion

The relationship between company hazard rates and the business cycle becomes more apparent after a financial crisis. To address this relationship, a regime-switching process with an intensity function is adopted in this paper. In addition, the dynamics of both interest rates and asset values are mod...

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Bibliographic Details
Published in:Quantitative finance 2016-04, Vol.16 (4), p.573-592
Main Authors: Chen, Son-Nan, Hsu, Pao-Peng, Li, Chang-Yi
Format: Article
Language:English
Subjects:
Bond markets
Business cycle
Business cycles
Credit spread
Markov analysis
Markov-modulated jump-diffusion model
Put & call options
Spread
Stock prices
Studies
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Summary:The relationship between company hazard rates and the business cycle becomes more apparent after a financial crisis. To address this relationship, a regime-switching process with an intensity function is adopted in this paper. In addition, the dynamics of both interest rates and asset values are modelled with a Markov-modulated jump-diffusion model, and a 2-factor hazard rate model is also considered. Based on this more suitable model setting, a closed-form model of pricing risky bonds is derived. The difference in yield between a risky bond and risk-free zero coupon bond is used to model a term structure of credit spreads (CSs) from which a closed-form pricing model of a call option on CSs is obtained. In addition, the degree to which the explicit regime shift affects CSs and credit-risky bond prices is numerically examined using three forward-rate functions under various business-cycle patterns.
ISSN:1469-7688
1469-7696
DOI:10.1080/14697688.2015.1058520