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A Radial Basis Function Approach to Credit Barrier Model

by Humphrey K.K. Wong of City University of Hong Kong,
Pascal Baup of Lehman Brothers (Toyko), and
Michael C.S. Wong of City University of Hong Kong

August 2007

Abstract: Albanese and et. al. (2003) and Avellaneda and Zhu (2001) develop the framework of Credit Barrier Model. They provide special solutions to the model in case of simple stochastic structure. The technical aspect of the model remains wide open for general stochastic structure that is crucial when the model is required to calibrate with aggregate amount of empirical data. This paper provides a technical solution to this problem with the use of radial basis function (RBF). This paper discusses the numerical implementation of the credit barrier model using the RBF method. It also demonstrates that the RBF method is numerically tractable in this problem and allows in the model richer stochastic structure capable of capturing relevant market information.

Keywords: Credit Migration, Kolmogorov Equation, Radial Basis Function.

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