Credit Default Swap Calibration and Derivatives Pricing with the SSRD Stochastic Intensity Model

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Credit Default Swap Calibration and Derivatives Pricing with the SSRD Stochastic Intensity Model

by Damiano Brigo of Banca IMI, and
Aurélien Alfonsi of Banca IMI

February 18, 2004

Abstract: In the present paper we introduce a two-dimensional shifted square-root diffusion (SSRD) model for interest rate derivatives and single-name credit derivatives, in a stochastic intensity framework. The SSRD is the unique model, to the best of our knowledge, allowing for an automatic calibration of the term structure of interest rates and of credit default swaps (CDS's). Moreover, the model retains free dynamics parameters that can be used to calibrate option data, such as caps for the interest rate market and options on CDS's in the credit market. The calibrations to the interest-rate market and to the credit market can be kept separate, thus realizing a superposition that is of practical value. We discuss the impact of interest-rate and default-intensity correlation on calibration and pricing, and test it by means of Monte Carlo simulation. We use a variant of Jamshidian's decomposition to derive an analytical formula for CDS options under CIR++ stochastic intensity. Finally, we develop an analytical approximation based on a Gaussian dependence mapping for some basic credit derivatives terms involving correlated CIR processes.

JEL Classification: G13.

AMS Classification: 60H10, 60J60, 60J75, 91B70.

Keywords: Interest-rate derivatives, credit derivatives, interest-rate intensity correlation, calibration, Monte Carlo simulation.

Published in: Finance and Stochastics, Vol. 9, No. 1, (January 2005), pp. 29-42.

Previously titled: Credit Default Swaps Calibration and Option Pricing with the SSRD Stochastic Intensity and Interest-Rate Model --and before that-- A Two-dimensional CIR++ Shifted Diffusion Model with Automatic Calibration to Credit Default Swaps and Interest-Rate Derivatives Data

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