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Pricing Equity Default Swaps

by Claudio Albanese of Imperial College, London, and
Oliver X. Chen of the National University of Singapore

November 2004

Abstract: Pricing credit-equity hybrids is a challenging task as the established pricing methodologies for equity options and credit derivatives are quite different. Equity default swaps provide an illuminating example of the clash of methodologies: from the equity derivatives viewpoint they are digital American puts with payments in installments and thus would naturally be priced by means of a local volatility model, but from the credit viewpoint they share features with credit default swaps and thus should be priced with a model allowing for jumps and possibly jump to default. The question arises of whether the two model classes can be consistent. In this paper we answer this question in the negative and find that market participants appear to be pricing equity default swaps by means of local volatility models not including jumps. We arrive at this conclusion by comparing a CEV model with an absorbing default barrier and a credit barrier model together with a credit-to-equity mapping that is calibrated to achieve consistency between equity option data, credit default swap spreads and historical credit transition probabilities and default frequencies.

Keywords: equity default swaps.

Published in: RISK, Vol. 18, No. 6, (June 2005), pp. 83-87.

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