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Review of Derivatives Research

, Volume 21, Issue 1, pp 119–148 | Cite as

Tempered stable structural model in pricing credit spread and credit default swap

  • Sung Ik Kim
  • Young Shin Kim
Article

Abstract

In this paper, we explore the features of a structural credit risk model wherein the firm value is driven by normal tempered stable (NTS) process belonging to the larger class of Lévy processes. For the purpose of comparability, the calibration to the term structure of a corporate bond credit spread is conducted under both NTS structural model and Merton structural model. We find that NTS structural model provides better fit for all credit ratings than Merton structural model. However, it is noticed that probabilities of default derived from the calibration of the term structure of a bond credit spread might be overestimated since the bond credit spread could contain non-default components such as illiquidity risk or asymmetric tax treatment. Hence, considering CDS spread as a reflection of the pure credit risk for the reference entity, we calibrate it in order to obtain more reasonable probability of default and obtain valid results in calibration of the market CDS spread with NTS structural model.

Keywords

Normal tempered stable process Structural model Credit risk Credit derivatives 

JEL Classification

C58 G12 G13 G31 E51 

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Copyright information

© Springer Science+Business Media, LLC 2017

Authors and Affiliations

  1. 1.Department of Applied Mathematics and StatisticsStony Brook UniversityStony BrookUSA
  2. 2.College of BusinessStony Brook UniversityStony BrookUSA

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