Flexing the Default Barrier

by Gregor Dorfleitner of Vienna University of Economics and Business Administration,
Paul Schneider of Vienna University of Economics and Business Administration, and
Tanja Veža of Vienna University of Economics and Business Administration

November 7, 2007

Abstract: The paper introduces a Black&Cox-type structural model for credit default swaps. The existing literature on structural CDS pricing is extended by allowing a general functional form for the default barrier specified without reference to asset volatilities, dividend yields and interest rates. We develop a fast and robust algorithm to compute survival probabilities numerically. An empirical application suggests that the market-implied barrier is stable over time, with a possibly hump-shaped term structure. The implied barrier can be used for computing survival probabilities consistent with objective expectations of asset evolution, for pricing under counterparty risk, and for determining optimal corporate bond covenants.

JEL Classification: C13, G12, G13, G15.

AMS Classification: 62P05, 68W25, 91-08.

Keywords: credit default swap, structural model, default boundary, the Green function.

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