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PRICING EQUITY DEFAULT SWAPS CLAUDIO ALBANESE AND OLIVER CHEN
 

Summary: PRICING EQUITY DEFAULT SWAPS
CLAUDIO ALBANESE AND OLIVER CHEN
Abstract. Pricing credit-equity hybrids is a challenging task as the estab-
lished pricing methodologies for equity options and credit derivatives are quite
different. Equity default swaps provide an illuminating example of the clash of
methodologies: from the equity derivatives viewpoint they are digital Amer-
ican puts with payments in installments and thus would naturally be priced
by means of a local volatility model, but from the credit viewpoint they share
features with credit default swaps and thus should be priced with a model al-
lowing for jumps and possibly jump to default. The question arises of whether
the two model classes can be consistent. In this paper we answer this question
in the negative and find that market participants appear to be pricing equity
default swaps by means of local volatility models not including jumps. We ar-
rive at this conclusion by comparing a CEV model with an absorbing default
barrier and a credit barrier model together with a credit-to-equity mapping
that is calibrated to achieve consistency between equity option data, credit
default swap spreads and historical credit transition probabilities and default
frequencies.
1. Introduction
Equity default swap (EDS) contracts have recently been launched and are ac-

  

Source: Albanese, Claudio - Department of Mathematics, King's College London

 

Collections: Mathematics