Multiscale Intensity Models for Single Name Credit Derivatives

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Multiscale Intensity Models for Single Name Credit Derivatives

by Evan Papageorgiou of Princeton University, and
Ronnie Sircar of Princeton University

February 7, 2007

Abstract: We study the pricing of defaultable derivatives, such as bonds, bond options, and credit default swaps in the reduced form framework of intensity-based models. We use regular and singular perturbation expansions on the intensity of default from which we derive approximations for the pricing functions of these derivatives. In particular, we assume an Ornstein-Uhlenbeck process for the interest rate, and a two-factor diffusion model for the intensity of default. The approximation allows for computational efficiency in calibrating the model. Finally, empirical evidence on the existence of multiple scales is presented by the calibration of the model on corporate yield curves.

JEL Classification: G12, G13.

Keywords: Defaultable bond, credit default swap, defaultable bond option, asymptotic approximation, time scales.

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