Stochastic volatility effects on defaultable bonds

Jean Pierre Fouque, Ronnie Sircar, Knut Sølna

Research output: Contribution to journalArticle

44 Scopus citations

Abstract

This paper studies the effect of introducing stochastic volatility in the first-passage structural approach to default risk. The impact of volatility time scales on the yield spread curve is analyzed. In particular it is shown that the presence of a short time scale in the volatility raises the yield spreads at short maturities. It is argued that combining first passage default modelling with multiscale stochastic volatility produces more realistic yield spreads. Moreover, this framework enables the use of perturbation techniques to derive explicit approximations which facilitate the complicated issue of calibration of parameters.

Original languageEnglish (US)
Pages (from-to)215-244
Number of pages30
JournalApplied Mathematical Finance
Volume13
Issue number3
DOIs
StatePublished - Sep 1 2006

All Science Journal Classification (ASJC) codes

  • Finance
  • Applied Mathematics

Keywords

  • Calibration
  • First-passage structural approach
  • Stochastic volatility
  • Time scales
  • Yield spreads

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