# Pricing Stochastic-Local Volatility Models with default

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1 Alma Mater Studiorum Università di Bologna SCUOLA DI SCIENZE Corso di Laurea magistrale in Matematica, Curriculum Generale-Applicativo Pricing Stochastic-Local Volatility Models with default Tesi di Laurea in Equazioni differenziali stocastiche Relatore: Chiar.mo Prof. Andrea Pascucci Presentata da: Monia Tomassini I Sessione Anno Accademico 2013/2014

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3 to Mattia

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5 Introduction In recent years is becoming increasingly important to handle credit risk. To value and to hedge credit risk in a consistent way, one needs to develop a quantitative model. The main objective of the quantitative models of the credit risk is to provide ways to price financial contracts that are sensitive to credit risk. This thesis deal with a local stochastic volatility model with default. Local stochastic volatility model is a continuous market model with non-constant volatility. In particular this model is an extension of the Black-Scholes one: the general idea is to modify the dynamics of the underlying asset, thus obtaining a model in which the volatility is a function of time and of the price of the underlying asset X. That is σ t = σ(t, X t ). This is due to the fact that, consistent with the observed market dynamics, implied volatilities today change as maturity and strike changes. Moreover, implied volatilities for fixed maturities and strikes also change over time and so volatility is non-constant. One advantage of local volatility models is that transition densities of the underlying as well as European option prices are often available in closed-form as infinite series of special functions. In order to take into account the possibility of bankruptcy of the counterparty of a contract, the models have to consider probability of default. Default is now permeating the valuation of derivatives in any area. Whenever a derivative is traded, the default risk of the counterparty should, in principle, enter the valuation. Recently, regulatory institutions insisted on the need to include this kind of risk in the pricing paradigm. Our goal is to develop a payoff depending on the underlying of the basic derivative and on the default of the counterparty. We will model the defaultable stock price process as a time-changed diffusion process with state-dependent local volatility. The stock price process will have local-stochastic i

6 ii Introduction volatility and default intensity. We will consider the JDCEV model of Carr and Linetsky (2006) and obtain a rich class of analytically tractable models with local-stochastic volatility and default intensity. These models can be used to jointly price equity and credit derivatives. This work is organized as follows: Chapter 1: in this chapter we will consider a random time i.e. a random variable whose value is interpreted as the time at which a given stochastic process exhibits a certain behavior of interest. We will analize the problem of the evaluation of conditional expectation when the filtration available G is formed by the natural filtration H of a random time and an arbitrary filtration F. We will introduce the concept of survival process and hazard process. Finally we will show an important lemma which allows to substitute the conditional expectation with respect to G t with the conditioning relative to the σ-algebra F t. Chapter 2: in this chapter we will present our model architecture. We will prove that assumption made in the previous chapter holds and so we can used the main results in our case. We will introduce the concept of the default time τ, a stopping time which represents the instant in which the counterparty goes bankrupt. We will present a defaultable asset S with risk-neutral dynamics. We will introduce the European option-pricing problem and derive a partial differential equation (PDE) for the price of an option. So we will show that the study of the price of our model can be transferred in the study of a partial differential operator with variables coefficients. Chapter 3: in this chapter we will provide some interesting examples. We will present the so called JDCEV model with respectively costant and stochastic short rate. As regards the stochastic case we will present two classical time-homogeneous shortrate models, namely the Vasicek (1977) and the Cox, Ingersoll and Ross (1985) models. We will show that both models possess an affine term structure: this argument acquires importance due to the fact that from an analytical and computational point of view the existence of an affine term structure extremely simplifies the content.

7 Introduction iii Chapter 4: we will introduce two numerical methods in order to approximate different bond prices. The former give an analytical approximation formulas and it is based on the notion of polynomial expansion basis: the idea is to expand the local volatility and drift functions as a Taylor series about an arbitrary point, i.e. f(x) = a n (x x) n n=0 in order to achieve their approximation result. We will derive a formal asymptotic expansion for the function that solves the option pricing PDE. These formulas are implemented in Wolfram Mathematica. The latter is based on Monte Carlo method, one of the most popular numerical methods, which allow to calculate approximately the price of the contract through several simulations. This method is implemented in Matlab. Chapter 5: Finally we will provide numerical examples that illustrate the effectiveness and versatility of our methods. We will tests every code and we will summarized in some tables the theoretical results obtained for each scheme. In the appendix there are some interesting theoretical results which are used in the thesis. Appendix A deals with Probability spaces, distributions and characteristic function. Appendix B treats of Stochastic process, Brownian motion and martingale. Appendix C deals with Stochastic differential equations and presents the Feynman-Ka c theorem, which shows the connection between SDEs and PDEs. It is essential to stress that we make the common standard technical assumptions: all filtrations satisfy the usual conditions 1 of right-continuity and completeness 1 Given a probability space (Ω, G, P) we say that G t satisfies the so-called usual hypotheses with respect to P if 1. N G 0 where N is the family of the events A s.t. P(A) = 0 2. the filtration is right-continuos i.e. for every t 0 G t = ε>0 G t+ε

8 iv Introduction the sample paths of all sthocastic processes are assumed to be càdlàg 2 all r.v. and s.p. satisfy suitable integrability conditions, which ensure the existence of considered conditional expectations, deterministic or stochastic integrals. 2 càdlàg is the French shortening for right-continuos with finite left limits at all t

9 Introduzione Negli ultimi anni sta diventando sempre più importante gestire il rischio di credito. Per la valutazione e per la copertura del rischio di credito in modo coerente, si ha la necessità di sviluppare un modello quantitativo. L obiettivo principale dei modelli quantitativi del rischio di credito è quello di fornire metodi per prezzi di contratti finanziari che sono sensibili al rischio di credito. Questa tesi tratta di modelli stocastici con volatilità locale. Un modello locale di volatilità stocastica è un modello continuo di mercato con volatilità non costante. In particolare, questo modello è un estensione di quello di Black-Scholes: l idea generale è quella di modificare la dinamica del sottostante, in modo da ottenere un modello in cui la volatilità è una funzione del tempo e del prezzo del sottostante. In altri termini σ t = σ(t, X t ). Ciò è dovuto al fatto che, in linea con le dinamiche di mercato osservate, le volatilità implicite cambiano al cambiare della scadenza e dello strike. Inoltre, fissati la scadenza e lo strike, le volatilità implicite cambiano anche nel tempo e così la volatilità è non costante. Un vantaggio dei modelli a volatilità locale è che le densità di transizione del sottostante - così come i prezzi delle opzioni europee - sono spesso disponibili in forma chiusa come una serie infinita di funzioni speciali. Al fine di tener conto della possibilità di fallimento della controparte di un contratto, i modelli devono considerare la probabilità di default. Il default è ormai diventato parte importante nella valutazione dei derivati. Ogni volta che un derivato viene scambiato, il rischio di default della controparte dovrebbe, in linea di principio, entrare nella valutazione. Recentemente, istituzioni di regolamentazione hanno insistito sulla necessità di includere questo tipo di rischio nel paradigma dei prezzi. Il nostro obiettivo è quello di sviluppare un payoff che dipenda dal sottostante v

10 vi Introduction del derivato di base e dal default della controparte. Modelleremo il processo del prezzo delle azioni con una volatilità locale dipendente dallo stato. Il processo di quotazione avrà volatilità locale stocastica e un default predefinito. Prenderemo in considerazione il modello di JDCEV di Carr e Linetsky (2006) ed otterremo una ricca classe di modelli analiticamente trattabili. Questa tesi è organizzata come segue: Capitolo 1: in questo capitolo prenderemo in considerazione un tempo casuale cioè una variabile aleatoria il cui valore viene interpretato come il tempo in cui un dato processo stocastico presenta un certo comportamento di interesse. Analizzeremo il problema della valutazione dell attesa condizionata quando la filtrazione disponibile G è formata da una filtrazione naturale H di un tempo casuale e da una filtrazione arbitraria F. Introdurremo il concetto di processo di sopravvivenza e di processo di pericolo. Infine mostreremo un lemma importante che permette di sostituire l attesa condizionata rispetto a G t con un attesa condizionata relativa alla σ-algebra F t. Capitolo 2: in questo capitolo presenteremo il nostro modello oggetto di studio. Dimostreremo che le ipotesi fatte nel capitolo precedente sono verificate e così potremo utilizzare i principali risultati ottennuti nel nostro particolare caso. Introdurremo il concetto di tempo di default τ, un tempo di arresto che rappresenta l istante in cui la controparte fallisce. Introdurremo il problema dell option-pricing europea e ricaveremo un equazione differenziale alle derivate parziali (PDE) per il prezzo di un opzione. Quindi dimostreremo che lo studio del prezzo del nostro modello può essere trasferito allo studio di un operatore differenziale alle derivate parziali con coefficienti variabili. Capitolo 3: in questo capitolo formiremo alcuni esempi interessanti. Presenteremo il cosiddetto modello JDCEV rispettivamente con tasso a breve costante e stocastico. Per quanto riguarda il caso stocastico presenteremo due classici modelli di tasso a breve, vale a dire il modello Vasicek (1977) e quello Cox, Ingersoll e Ross (1985). Mostreremo che entrambi i modelli possiedono una struttura affine: tale argomento acquista particolare importanza grazie al fatto che da un punto di vista analitico e

11 Introduction vii computazionale l esistenza di una struttura affine semplifica estremamente il contenuto. Capitolo 4: introdurremo due metodi numerici per approssimare diversi prezzi dei bond. Il primo fornisce formule d approssimazione analitiche e si basa sulla nozione di espansione di una base polinomiale: l idea è quella di espandere la volatilità locale e la funzione di drift come una serie di Taylor intorno a un punto arbitrario, vale a dire f(x) = a n (x x) n n=0 al fine di raggiungere un risultato approssimato. Deriveremo una formula di sviluppo asintotico per la funzione che risolve i prezzi dell opzione. Queste formule sono state poi implementate in Wolfram Mathematica. L ultimo è basato sul metodo Monte Carlo, uno dei metodi numerici più popolari, che permette di calcolare approsimativamente il prezzo del contratto attraverso diverse simulazioni e facendone la media. Questo metodo è stato poi implementato in Matlab. Chapter 5: infine forniremo esempi numerici che illustreranno l efficacia e la versatilità dei metodi studiati. Testeremo ogni algoritmo implementato e riassumeremo in alcune tabelle i risultati teorici ottenuti. Nell appendice sono riportati alcuni risultati teorici interessanti che sono utilizzati nella tesi. L appendice A si occupa di spazi di probabilità, distribuzioni e funzione caratteristica. L appendice B tratta di processi stocastici, moto browniano e martingale. L appendice C invece tratta di equazioni differenziali stocastiche e presenta il teorema di Feynman-Ka c, che mostra il legame tra SDE and PDE. Riportiamo di seguito le ipotesi tecniche che assumiamo valide per tutta la tesi: ogni filtrazione soddisfa le ipotesi usuali 3 di continuità e completezza 3 Dato uno spazio di probabilità (Ω, G, P) diciamo che G t soddisfa le ipotesi usuali rispetto a P se 1. N G 0 dove N è la famiglia degli eventi A t.c. P(A) = 0

12 viii Introduction i cammini di tutti i processi stocastici si assumono essere càdlàg 4 tutte le variabili aleatorie e i processi stocastici soddisfano le condizioni di integrabilità adeguate che garantiscono l esistenza di attese condizionate, integrali deterministici o stocastici. 2. la filtrazione è continua da destra ovvero per ogni t 0 G t = ε>0 G t+ε 4 càdlàg è un abbreviazione francese che sta per continuità da desta con limite da destra finito in t

13 Contents Introduction Introduzione i v General notations 1 1 Preliminary results Market assumptions Construction of the model Default time Market model with costant short interest Option pricing Market model with stochastic short interest Examples JDCEV Model Affine term structure Vasicek model CIR model Numerical method Taylor series expansion Monte Carlo Method Confidence interval ix

14 x CONTENTS Euler scheme Results JDCEV model with costant interest JDCEV model with sthocastic interest: Vasicek model JDCEV model with sthocastic interest: Cir model Conclusions and future work 63 A Probability spaces 65 A.1 Distributions A.1.1 Exponential distribution A.1.2 Gaussian distribution A.2 Fourier transform A.2.1 Gaussian Fourier characteristic function A.3 Conditional expectation B Stochastic process 71 B.1 Brownian Motion B.2 Equivalent Martingale Measure (EMM) C Stochastic differential equations 75 C.1 Linear SDE C.2 Fundamental solution and transition density Bibliography 79

15 List of Figures 3.1 Path of Vasicek processes Path of CIR processes Bond price as a function of time Path of X xi

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17 General notations N = {0, 1, 2, 3, } is the set of natural numbers R is the set of real numbers R + =]0, + [ I H is the indicator function of H A C = Ω A is the complementary of A (referred to events) E[X] := E P [X] (referred to random variables) For any a, b R a b = min{a, b} a b = max{a, b} Function spaces B m = space of B-measurable functions L p = space of functions integrable of order p L p loc = space of functions locally integrable of order p C k = space of functions with continuos derivates up to order k N Process spaces L p = space of progressively measurable process in L p ([0, T ] x Ω) 1

18 2 LIST OF FIGURES L p loc = space of progressively measurable process X s.t. X(ω) Lp ([0, T ]) for almost any ω Abbreviations r.v.= random variable s.p.= stochastic process s.t.= such that i.i.d.= independent and identically distribueted (referred to random variables) mg= martingale B.m.= Brownian motion i.e.= id est that is PDE= Partial Differential Equation SDE= Stochastic Differential Equation

19 Chapter 1 Preliminary results Let us start with some general remarks which will be useful for the costruction of our defaultable model. Let τ : Ω R be a non-negative r.v. on a probability space (Ω, G, P). For our model τ represents the random time. For convenience we assume: P(τ = 0) = 0 P(τ > t) > 0 for any t R + The last condition means that τ is assumed to be unbonded. Definition 1.1. We define the jump process H associated with the random time τ by setting H t = I {τ t} for t R + The process H has right-continuos sample paths. Specifically each sample paths is equal to 0 before random time τ and it equals 1 for t τ. Let H = (H t ) t 0 stand for the filtration generated by the process H where H t is the σ-algebra defined by H t = σ(h u : u t). Finally we set H = σ(h u : u R + ). The σ-algebra H t represents the information generated by the observations on the time interval [0, t]. Let F = (F t ) t 0 be an arbitrary filtration on a probability space (Ω, G, P). All filtration are assumed to satisfy usual condition of right continuity and completeness. We assume that the filtration G has the form G = F H i.e. G t = F t H t for any 3

20 4 1. Preliminary results t R +. For each t R +, the information available at time t is captured by the σ-algebra G t. We want to stress that the process H is obviosly G-adapted, but it is not necessary F-adapted. In other words, the random time τ is a G-stopping time 1, but it may fail to be an F-stopping time. Definition 1.2. For any t R + we denote by G the F-survival process of τ with respect to the filtration F, given as: G t = P(τ > t F t ) t R + Remark 1. G t is F t -measurable thanks to the properties of conditional expectation. (See A.3). Remark 2. Since F 0 contains no information, we have: G 0 = P(τ > 0 F 0 ) = P(τ > 0) > 0 The hazard process of the default time, given the flow of information represented by the filtration F is formally introduced through the following definition. Definition 1.3. Assume that G t > 0 for any t R +. Then: Γ t := ln G t t R + is called the F-hazard process of τ. Remark 3. It is important to observe that for any A G t we have A {τ > t} = B {τ > t} for some event B F t. Indeed we have two possibilities: if A = {τ u} for some u t B F t s.t. A {τ > t} = B {τ > t}. It is enough to take B =. if A F t B F t s.t. A {τ > t} = B {τ > t}. It is enough to take B = A. 1 In a filtered space (Ω, G, (G t ), P) a r.v. τ : Ω R + is called stopping time with respect to the filtration (G t ) if {τ t} G t t 0 Clearly a deterministic time τ t is a stopping time.

21 5 The following lemma give an important result. It allows to substitute the conditional expectation with respect to G t with the conditioning relative to the σ-algebra F t. Switching from G t expectations to F t expectations is important because for some variables the F t conditional expectations are easier to compute. Lemma 1. Let Y be a r.v. on a probability space (Ω, G, P). Then for any t R + we have: Proof. We need to verify that (recall that F t G t ) E[I {τ>t} Y G t ] = P(τ > t G t ) E[I {τ>t}y F t ] G t (1.1) E[I {τ>t} Y P(τ > t F t ) G t ] = E[I {τ>t} E[I {τ>t} Y F t ] G t ] We need to show that for any A G t we have: I {τ>t} Y P(τ > t F t )dp = A A I {τ>t} E[I {τ>t} Y F t ]dp In view of the previous remark for any A G t we have A {τ > t} = B {τ > t} for some event B F t and so: I {τ>t} Y P(τ > t F t )dp = A = = = = = = = = A {τ>t} B {τ>t} B B B B Y P(τ > t F t )dp = Y P(τ > t F t )dp = I {τ>t} Y P(τ > t F t )dp = E[I {τ>t} Y F t ]E[I {τ>t} F t ]dp = E[I {τ>t} E[I {τ>t} Y F t ] F t ]dp = I {τ>t} E[I {τ>t} Y F t ]dp = B {τ>t} A {τ>t} A E[I {τ>t} Y F t ]dp = E[I {τ>t} Y F t ]dp = I {τ>t} E[I {τ>t} Y F t ]dp =

22 6 1. Preliminary results Where in those steps the only properties that we have used are simply the properties of conditional expectation (See A.3). Corollary 1. If H t G t then: Proof. E[I {τ>t} Y G t ] = I {τ>t} E[I {τ>t} Y F t ] G t (1.2) It suffices to observe that, since H t G t and H t is H t -measurable, we have P(τ > t G t ) = E[I {τ>t} G t ] = I {τ>t} In the last equality we have used the properties of conditional expectation (See A.3). The formula (1.2) can be rewritten as follows: E[I {τ>t} Y G t ] = I {τ>t} E[I {τ>t} e Γt Y F t ] (1.3) Lemma 2. Let Y be a r.v. on a probability space (Ω, G, P) and let t T. Then: E[I {τ>t } Y G t ] = I {τ>t} E[I {τ>t } e Γt Y F t ] (1.4) If Y is F -measurable, then E[I {τ>t } Y G t ] = I {τ>t} E[e Γt Γ T Y F t ] (1.5) Proof. In view of (1.3), to show that (1.4) holds, it is enough to observe that I {τ>t } I {τ>t} = I {τ>t }. For (1.5), by virtue of (1.4), we obtain E[I {τ>t } Y G t ] = I {τ>t} E[I {τ>t } e Γt Y F t ] = = I {τ>t} E[E[I {τ>t } F T ]e Γt Y F t ] = I {τ>t} E[P(τ > T F T )e Γt Y F t ] = I {τ>t} E[G T e Γt Y F t ] = I {τ>t} E[e Γt Γ T Y F t ]

23 1.1 Market assumptions Market assumptions Before proceeding to the description of the models that will be discussed below, it is useful to mention the properties of the financial market that are taken as the assumptions on which these models are built. Some of these issues do not exist in real markets, but they serve to simplify the mathematical treatment of the problem. It is assumed that the market is free of arbitrage opportunities. The absence of arbitrage is an important concept in the mathematical theory of contingent claim pricing which imposes constraints on the way instruments are priced in a market. The word absence of arbitrage essentially addresses the opportunity to make a risk-free profit: it is equivalent to the impossibility to invest zero today and receive tomorrow a nonnegative amount that is positive with positive probability. In other words, two portfolios having the same payoff at a given future date must have the same price today. An important concept in the mathematical theory of contingent claim pricing is risk-neutral pricing. It represents the price of any instrument in an arbitrage-free market as its discounted expected payoff under an appropriate probability measure. It is assumed the existence of an equivalent martingale measure 2 which leads to absence of arbitrage. It is assumed frictionless market i.e. a financial market without transaction costs. 2 See (B.5)

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25 Chapter 2 Construction of the model Our goal is, using the previous notations, to costruct a market model with default. Let (Ω, G, (G t ) t 0, P) a filtered probability space. All stochastic processes defined below live on this probability space and all expectations are taken with respect to P. 1. Let W = (W t ) t 0 be a real B.m Let ε be a r.v. with exponential distribution with parameter 1 i.e. ε exp(1) 2 and independent of W. 3. Let X be a process which is the solution of the follow SDE 3 : where: dx t = µ(t, X t )dt + σ(t, X t )dw t (2.1) µ = µ(t, x) : [0, T ] x R R is a measurable 4 function σ = σ(t, x) : [0, T ] x R R is a non-negative measurable function 4. Let γ : [0, + [ x R R non-negative measurable function. 1 See (B.3) 2 See (A.1.1) 3 See (C.1) 4 In a measure space (Ω, F, P) we say that a function f : Ω R is F -measurable if f 1 (H) F for any H B 9

26 10 2. Construction of the model We define τ : Ω R be a non-negative r.v. on a probability space (Ω, G, P) by setting: τ = inf{t 0 : t 0 γ(s, X s )ds ε} We shall now check that properties listed in the previous chapter are satisfied. First of all we show that P(τ = 0) = 0. Since clearly {τ = 0} = { 0 0 γ(s, X s)ds ε} we have: P(τ = 0) = P(0 ε) = 0 Now we show that P(τ > t) > 0 for any t R +. Before to prove this equality we have to introduce this lemma. Lemma 3. Let X,Y be a r.v. on (Ω, G, P). Let F G be a σ-algebra s.t. X is independent of F ; Y is F -measurable. Then for every B-measurable bounded function h we have E[h(X, Y ) G ] = g(y ) where g(y) = E[h(X, y)] (2.2) Proof. We have to prove that the r.v. g(y ) is a version of the conditional expectation of h(x, Y ). i.e. that for any G F we have h(x, Y )dp = g(y )dp G G Using the notation P W to denote the distribution of a given r.v. W, we have g(y) = h(x, y)p X (dx) R Then, since g is a B-measurable function, by assumption ii) results that g(y ) is a F -

27 11 measurable. Further, given G F and putting Z = I G, we get h(x, Y )dp = h(x, Y )ZdP = h(x, y)zp (X,Y,Z) (d(x, y, z)) = G Ω = h(x, y)zp X (dx)p (Y,Z) (d(y, z)) = = g(y)zp (Y,Z) (d(y, z)) = = g(y )dp G Where in third equality we have used the independence assumption i) and in fourth equality Fubini s theorem. Now we can show that P(τ > t) > 0. Since {τ > t} = { t γ(s, X 0 s)ds < ε} we have: P(τ > t) = P( t 0 γ(s, X s )ds < ε) = E[I { t γ(s,xs)ds<ε}] = E[E[I 0 { t γ(s,xs)ds<ε} F t]] = 0 = E[P( t 0 γ(s, X s )ds < ε F t )] Since ε is independent of F and { t γ(s, X 0 s)ds < ε} is F t -measurable, using the lemma we obtain: P(τ > t) = E[h( t 0 γ(s, X s )ds)] Where h(x) = P(ε > x) and since ε has an exponential distribution we have This ends the proof. E[h( Remark 4. Thanks to lemma we have P(τ > t F t ) = P( t 0 t 0 γ(s, X s )ds] > 0 Therefore the F-survival process of τ is positive i.e. γ(s, X s )ds < ε F t ) = e t 0 γ(s,xs)ds > 0 (2.3) G t = P(τ > t F t ) > 0 t R + So the F-hazard process of τ is well defined i.e. Γ t := ln G t t R +

28 12 2. Construction of the model Since G t = e Γt, by (2.3) we obtain: Γ t := t 0 γ(s, X s )ds (2.4) Therefore the random time τ is seen as the first time when the hazard process Γ is greater or equal to the random level ε exp(1) i.e. τ = inf{t 0 : Γ t ε} 2.1 Default time In recent years is becoming increasingly important to handle credit risk. Credit risk is the risk associated with the possibility of bankruptcy. More precisely, if a derivative provides for a payment at cert time T but before that time the counterparty defaults, at maturity the payment cannot be effectively performed, so the owner of the contract loses it entirely or a part of it. It means that the payoff of the derivative, and consequently its price, depends on the underlying of the basic derivative and on the risk of bankruptcy of the counterparty. To value and to hedge credit risk in a consistent way, one needs to develop a quantitative model. The standard way to model the counterparty risk of bankruptcy is to introduce the default time τ : it is a stopping time which represents the instant in which the counterparty goes bankrupt. Default time is introduced because it gives information which is not contained in the usual filtration F. In order to keep track of the event {τ t} we have introduce the filtration H = (H t ) t 0 stand for the filtration generated by a default indicator process H defined in the previous chapter i.e. H t = I {τ t} for t R + Therefore if we want a filtration which provides for the whole flow of information, we should introduce an enlarged filtration G = F H i.e. G t = F t H t for any t R +. The filtration G represents the history of the market. It describes the default-free market variables up to t (by filtration F t ) and tells whether default occurred before t (by filtration H t ). Now we can defined our model.

29 2.2 Market model with costant short interest Market model with costant short interest In this section we will look at default model with deterministic interest rates. For simplicity, we assume a frictionless market, no arbitrage, zero interest rates and no dividends. We take, as given, an equivalent martingale measure P 5 chosen by the market on a complete filtered probability space (Ω, G, (G t ) t 0, P) satisfying the usual hypothesis of completeness and right continuity. The filtration G is defined as above and F is the filtration generated by X. We consider a defaultable asset S whose risk-neutral dynamics are given by S t = I {τ>t} e Xt dx t = µ(t, X t )dt + σ(t, X t )dw t τ = inf{t 0 : t 0 γ(s, X s )ds ε} (2.5) dx t may be interpreted as the change in X t over the period [t, t + dt] µ(t, X t ) and σ(t, X t ) are deterministic functions of X t and t τ represents the default time of S and is the first arrival time of a process with local intensity function γ(t, x) > 0 We assume that the coefficients are measurable in t and suitably smooth in x to ensure the existence of a solution to (2.5). In the absence of arbitrage, S must be an G-martingale 6. We define M t = e rt S t. It represents the discounted value of the asset. We have to prove that the equality M t = [M T G t ] holds for t T. Since (2.4) holds and e X T is F t -measurable we can apply the lemma 2 of the previous 5 See (B.5) 6 See (B.4).

30 14 2. Construction of the model chapter. M t = E[M T G t ] e rt S t = E[e rt S T G t ] S t = E[e r(t T ) S T G t ] e Xt I {τ>t} = e r(t T ) E[e X T I {τ>t } G t ] e Xt I {τ>t} = e r(t T ) I {τ>t} E[e X T T t γ(s,x s)ds F t ] e Xt = e r(t T ) E[e X T T t γ(s,x s)ds F t ] e Xt rt t 0 γ(s,xs)ds = E[e X T rt T 0 γ(s,xs)ds F t ] Therefore M t is a G-mg Y t := e Xt rt t 0 γ(s,xs)ds is a F-mg. The drift condition follows by applying the Ito s formula to the process e Xt rt t 0 γ(s,xs)ds and setting the drift term to zero i.e. dy t = Y t ( r γ(t, X t ))dt + Y t dx t Y td < X > t = Y t ( r γ(t, X t ))dt + Y t µ(t, X t )dt + Y t σ(t, X t )dw t Y tσ 2 (t, X t )dt = Y t ( r γ(t, X t ) + µ(t, X t ) σ2 (t, X t ))dt + Y t σ(t, X t )dw t Therefore: r γ(t, X t ) + µ(t, X t ) σ2 (t, X t ) = 0 = µ(t, X t ) = r + γ(t, X t ) 1 2 σ2 (t, X t ) Thus, in order to guarantee that M t is a mg we have to impose tha additional restrictions on the drift µ(t, X t ) i.e. µ(t, X t ) is fixed by σ(t, X t ), γ(t, X t ) and r. where r is the risk-free rate σ 2 (t, x) is the local volatility γ(t, X t ) is the intensity function of default And so: dx t = µ(t, X t )dt + σ(t, X t )dw t dx t = (r + γ(t, X t ) 1 2 σ2 (t, X t ))dt + σ(t, X t )dw t (2.6)

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