Journal ArticleDOI
Credit spreads, optimal capital structure, and implied volatility with endogenous default and jump risk
Nan Chen,Steven Kou +1 more
TLDR
In this article, a two-sided jump model for credit risk was proposed by extending the Leland-Toft endogenous default model based on the geometric Brownian motion, which showed that jump risk and endogenous default can have significant impacts on credit spreads, optimal capital structure, and implied volatility of equity options.Abstract:
We propose a two-sided jump model for credit risk by extending the Leland–Toft endogenous default model based on the geometric Brownian motion. The model shows that jump risk and endogenous default can have significant impacts on credit spreads, optimal capital structure, and implied volatility of equity options: (1) Jumps and endogenous default can produce a variety of non-zero credit spreads, including upward, humped, and downward shapes; interesting enough, the model can even produce, consistent with empirical findings, upward credit spreads for speculative grade bonds. (2) The jump risk leads to much lower optimal debt/equity ratio; in fact, with jump risk, highly risky firms tend to have very little debt. (3) The two-sided jumps lead to a variety of shapes for the implied volatility of equity options, even for long maturity options; although in general credit spreads and implied volatility tend to move in the same direction under exogenous default models, this may not be true in presence of endogenous default and jumps. Pricing formulae of credit default swaps and equity default swaps are also given. In terms of mathematical contribution, we give a proof of a version of the “smooth fitting” principle under the jump model, justifying a conjecture first suggested by Leland and Toft under the Brownian model.read more
Citations
More filters
Journal ArticleDOI
Rollover Risk and Credit Risk
Zhiguo He,Wei Xiong +1 more
TL;DR: In this article, Chen et al. developed a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk, which shows the role of short-term debt in exacerbating roll-over risk.
Journal Article
Credit Risk: Pricing, Measurement, and Management
TL;DR: Duffie and Singleton as mentioned in this paper proposed a way of integrating credit and market risks in a portfolio model, which can be viewed as a component of market risk and may generate credit risk.
Journal ArticleDOI
Rollover Risk and Credit Risk
Zhiguo He,Wei Xiong,Wei Xiong +2 more
TL;DR: This paper showed that deterioration of debt market liquidity not only leads to an increase in liquidity premium of corporate bonds but also credit risk, and highlighted the role of short-term debt in exacerbating rollover risk.
Journal ArticleDOI
Pricing discretely monitored barrier options and defaultable bonds in lévy process models: a fast hilbert transform approach
Liming Feng,Vadim Linetsky +1 more
TL;DR: In this article, the authors present a method to price discretely monitored single and double-barrier options in Levy process-based models, which involves a sequential evaluation of Hilbert transforms of the product of the Fourier transform of the value function at the previous barrier monitoring date and the characteristic function of the Levy process.
Book ChapterDOI
Chapter 2 Jump-Diffusion Models for Asset Pricing in Financial Engineering
TL;DR: In this article, the authors focus on the following issues related to jump-diffusion models for asset pricing in financial engineering: the controversy over tailweight of distributions, identifying a risk-neutral pricing measure by using the rational expectations equilibrium, using Laplace transforms to pricing options, including European call/put options, pathdependent options, such as barrier and lookback options, Difficulties associated with the partial integro-differential equations related to barrier-crossing problems, and analytical approximations for finite-horizon American options with jump risk.
References
More filters
Journal ArticleDOI
The Pricing of Options and Corporate Liabilities
Fischer Black,Myron S. Scholes +1 more
TL;DR: In this paper, a theoretical valuation formula for options is derived, based on the assumption that options are correctly priced in the market and it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks.
Journal Article
The Cost of Capital, Corporation Finance and the Theory of Investment
TL;DR: In this article, the effect of financial structure on market valuations has been investigated and a theory of investment of the firm under conditions of uncertainty has been developed for the cost-of-capital problem.
Journal ArticleDOI
On the pricing of corporate debt: the risk structure of interest rates
TL;DR: In this article, the American Finance Association Meeting, New York, December 1973, presented an abstract of a paper entitled "The Future of Finance: A Review of the State of the Art".
Journal ArticleDOI
The Determinants of Capital Structure Choice
TL;DR: In this paper, the explanatory power of some of the recent theories of optimal capital structure is analyzed empirically and a factor-analytic technique is used to mitigate the measurement problems encountered when working with proxy variables.
Journal ArticleDOI
Option pricing when underlying stock returns are discontinuous
TL;DR: In this article, an option pricing formula was derived for the more general case when the underlying stock returns are generated by a mixture of both continuous and jump processes, and the derived formula has most of the attractive features of the original Black-Scholes formula.