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Credit Derivatives Pricing with a Smile-Extended Jump Stochastic Intensity Model

by Damiano Brigo of Banca IMI, and
Naoufel El-Bachir of the University of Reading

December 5, 2006

Abstract: We present a two-factor stochastic default intensity and interest rate model for pricing single-name default swaptions. The specific positive square root processes considered fall in the relatively tractable class of affine jump diffusions while allowing for inclusion of stochastic volatility and jumps in default swap spreads. The parameters of the short rate dynamics are first calibrated to the interest rates markets, before calibrating separately the default intensity model to credit derivatives market data. A few variants of the model are calibrated in turn to market data, and different calibration procedures are compared. Numerical experiments show that the calibrated model can generate plausible volatility smiles. Hence, the model can be calibrated to a default swap term structure and few default swaptions, and the calibrated parameters can be used to value consistently other default swaptions (different strikes and maturities, or more complex structures) on the same credit reference name.

JEL Classification: C15, C63, C65, G12, G13.

Keywords: Credit Derivatives, Credit Default Swap, Credit Default Swaption, Jump-Diffusion, Stochastic Intensity, Doubly Stochastic Poisson Process, Cox Process.

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