Default Swap Games Driven by Spectrally Negative Lévy Processes

by Masahiko Egami of Kyoto University,
Tim S.T. Leung of Columbia University, and
Kazutoshi Yamazaki of Osaka University

September 27, 2012

Abstract: This paper studies game-type credit default swaps that allow the protection buyer and seller to raise or reduce their respective positions once prior to default. This leads to the study of an optimal stopping game subject to early default termination. Under a structural credit risk model based on spectrally negative Lévy processes, we apply the principles of smooth and continuous fit to identify the equilibrium exercise strategies for the buyer and the seller. We then rigorously prove the existence of the Nash equilibrium and compute the contract value at equilibrium. Numerical examples are provided to illustrate the impacts of default risk and other contractual features on the players' exercise timing at equilibrium.

JEL Classification: C73, G13, G33, D81.

AMS Classification: 91A15, 60G40, 60G51, 91B25.

Keywords: optimal stopping games, Nash equilibrium, Lévy processes, scale function, credit default swaps.

Published in: Stochastic Processes and their Applications, Vol. 123, No. 2, (February 2013), pp. 347-384.

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