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Stochastic Volatility Effects on Defaultable Bonds

by Jean-Pierre Fouque of North Carolina State University,
Ronnie Sircar of Princeton University, and
Knut Sølna of the University of California Irvine

October 24, 2005

Abstract: We study the effect of introducing stochastic volatility in the first passage structural approach to default risk. We analyze the impact of volatility time scales on the yield spread curve. In particular we show that the presence of a short time scale in the volatility raises the yield spreads at short maturities. We argue that combining first passage default modeling with multiscale stochastic volatility produces more realistic yield spreads. Moreover this framework enables us to use perturbation techniques to derive explicit approximations which facilitate the complicated issue of calibration of parameters.

Keywords: default, stochastic volatility.

Published in: Applied Mathematical Finance, Vol. 13, No. 3, (September 2006), pp. 215-244.

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