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**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-

tively traded in increasing volumes. From the credit modelling viewpoint, EDS

contracts are structured similarly to credit default swap (CDS) contracts, except

that payouts occur when an equity default event happens, as opposed to a credit

default event. Typical maturities are of 5 years and payment frequencies are semi-

annual. By deﬁnition, equity default occurs whenever a given share price drops

below 30% of the spot value at initiation of the contract. Equity default events for

publicly traded companies are easily documentable.

EDS contracts command higher spreads than CDS contracts as credit defaults

subsume equity defaults. This allows for several interesting trading strategies such

as the EDS/CDS carry trade, whereby an investor sells EDS protection and buys

CDS protection on the same name. In the case that no equity default event occur-

ring prior to maturity, the investor will have gains due to the diﬀerence between

EDS and CDS spreads. In the case that a credit default occurs the investor is

hedged unless the recovery rate on the CDS leg is less than 50%. Losses occur if

an equity default event occurs prior to maturity but is not accompanied by credit

default. As we discuss in this article, model risk is also an important factor to take

into consideration.

This work was completed while Oliver Chen was visiting Imperial College. The authors were

supported in part by the Natural Science and Engineering Research Council of Canada. We thank

Chris Long, Tom Picking and the participants to the Risk Conferences on Stochastic Volatility

2004, Risk USA 2004 and the European Credit Risk Summit 2004 for useful discussions. We

are indebted to two very helpful referees who shared useful insights with their comments. All

remaining errors are our own.

1

2 CLAUDIO ALBANESE AND OLIVER CHEN

Another typical trade is to enhance the yield of synthetic collateralized debt obli-

gations (CDOs) by creating pockets of EDS positions or even creating a synthetic

equity collateralized obligation (ECO) by a portfolio of only EDS contracts. The

challenge from the pricing viewpoint is to determine the fair value for the ratio

between CDS and EDS spreads and thus suitable replication strategies. In this

paper, we ﬁnd that this ratio is quite sensitive to the modeling assumptions.

From the equity modeling viewpoint, EDS contracts are structured as far out-

of-the-money American digitals with payments in semiannual installments. The

standard market practice for barrier options would be to use a local volatility model

calibrated to European options. In the case of EDS contracts however, the practice

is questionable due to the extreme out of the money character of the strike. In

fact, the magnitude of the drop in share price needed to trigger the payout of an

EDS will likely occur concurrently with a deterioration in the credit rating of the

ﬁrm, implying major changes in the capital structure of the ﬁrm. In turn, this

can lead to quite diﬀerent values for implied volatilities and a modiﬁcation of the

corresponding implied volatility process.

The point of view we take in this paper is that in order to properly specify a

model for EDS contracts one should calibrate to aggregate data for ﬁrms across

all credit ratings to ensure that the model remains consistent if a drastic drop in

equity price occurs.

Besides the volatility, a second issue is the presence of jumps. In credit models

for credit default swaps, convertible bonds and credit baskets it is customary to

include jumps. This is a common feature of all credit models which has substantial

repercussions on the size of EDS spreads. Qualitatively, the presence of jumps

increase the CDS spread to EDS spread ratio to approach 100%. In this paper we

attempt to quantify the diﬀerence using the credit barrier models introduced in

Albanese, Campolieti, Chen and Zavidonov (2003) and Albanese and Chen (2004),

combined with a new technique for credit-equity mapping designed to price credit-

equity hybrids.

In the version of Albanese et al. (2003), credit barrier models for the credit

quality process are calibrated to market data in both the statistical and pricing

measures. It was shown that under the statistical measure, historical averages of

rating transition and default probabilities can be replicated with accuracy across

all rating classes. In this analysis, we make use of through-the-cycle ratings, as

opposed to point-in-time rating systems such as expected default frequencies. It is

our opinion that cycle dependencies are an important but secondary eﬀect which

can be taken into account by a reﬁnement of the model, but this would add technical

complexities which there is merit to avoid in a ﬁrst approximation. Upon applying

a risk-neutralizing drift, the model spread rates in the pricing measure are in good

agreement with market aggregate spread rates. The diﬀerence between model and

market rates can be explained by ﬁnancially meaningful forward liquidity spreads.

In order to price EDS contracts, we use a credit quality to equity price mapping

on top of the credit barrier model so that the information in the credit markets is

imparted into the equity process.

Once mapped into an equity option model, we ﬁnd that our calibrated credit

barrier model leads to a local volatility proﬁle quite similar to a CEV speciﬁcation,

except that jumps need to be present in the process to achieve consistency with

historical transition probabilities. We thus compare EDS prices obtained with

PRICING EQUITY DEFAULT SWAPS 3

two procedures: (i) by using the credit barrier model with jumps and a credit to

equity map, and (ii) by calibrating a CEV local volatility pure diﬀusion model with

absorption at zero to single name at-the-money implied equity option volatilities

and CDS spreads. Using the CEV model, we ﬁnd that the ratio of EDS to CDS

spreads can be as large as 8:1. Instead, a credit barrier model including jumps can

only be consistent with ratios of at most 2:1. Comparing with market quotes, we

conclude that currently jumps do not appear to be priced.

The article is organized as follows: section 2 gives the speciﬁcation of the credit

to equity mapping and describes the calibration procedure. We then price EDS

contracts in section 3. Section 4 prices EDS contracts using a pure diﬀusion process

of CEV type with defaults. Section 5 concludes.

2. Credit quality to equity mapping

As explained in the introduction, credit barrier models are calibrated to aggre-

gate data, namely credit transition probabilities, historical default probabilities and

average credit default swap spreads in the investment grade sectors. To reconcile

the statistical with the pricing information, the market price of credit risk is esti-

mated and yield spreads are disentangled into a sum of credit, taxation and liquidity

spreads. Referring to our previous papers Albanese et al. (2003) and Albanese and

Chen (2004) for a description of the mathematical framework and calibration issues,

we describe here in detail the construction of the credit-to-equity mapping.

It is challenging to ﬁt together in a comprehensive framework the three inter-

acting shocks coming from the CDS market making, the stock market making and

the volatility market making. There is no a-priori reason why these three shocks

should be driven by a single factor. However, one would expect that conditioned

to a rare event such as equity or credit default occurring, the three market makers

would act the same way. Assuming conditional collinearity of the relevant shocks,

one is led to construct one factor models where equity is deterministically linked to

credit quality.

Deﬁne a credit quality variable y which can take values on a discrete lattice of

points Λ

N

= {y

n

}

N

n=0

with time restricted to a discrete set of points t

i

= i∆t where

∆t is a ﬁxed time interval such as one quarter. The parameters for the speciﬁcation

of the pricing measure Q are obtained by calibrating against aggregate corporate

bond prices. The kernel of transition probabilities on the lattice Λ

N

and on the

discrete time lattice is denoted by:

U

ti,tj

(m, n) = Q(y(t

j

) = y

n

|y(t

i

) = y

m

) 0 ≤ i ≤ j ≤ I, 0 ≤ m, n ≤ N.

In addition, we have an absorbing state y

−1

which we consider to be the state of

default and for which we have the probabilities of default:

U

ti,tj

(m, −1) = Q(y(t

j

) = y

−1

|y(t

i

) = y

m

) 0 ≤ i ≤ j ≤ I, 0 ≤ m ≤ N.

Let t

I

= I∆t be the date up to which we need to generate the credit quality and

equity processes. For a given debt-issuer which is also a publicly traded company,

at time t = 0 we let the initial stock price be S

0

and the initial credit quality be

y(0). We wish to specify the equity process S(t) as a function of the credit quality

y(t) for t = t

1

, . . . , t

I

.

Since credit quality is not a tradeable asset, the credit quality process need

not be a martingale process even in the pricing measure. However, in order to

avoid arbitrage opportunities the discounted equity process e

−(r−q)t

S(t) must be a

4 CLAUDIO ALBANESE AND OLIVER CHEN

martingale process in the pricing measure, where r is the risk-free rate and q is the

continuously compounded dividend yield, both of which we assume to be constant.

Speciﬁcally, we require that:

E

Q

e

−(r−q)tj

S(t

i

+ t

j

) |S(t

i

)

= S(t

i

) (1)

where 0 ≤ i ≤ I and 0 ≤ j ≤ I − i. To ensure that equation (1) is satisﬁed, we

can specify the credit quality to equity mapping at maturity t

I

by a univariate

function Φ. For the equity prices at times t

i

previous to maturity, we compound

the expectation of Φ conditional to the credit quality at t

i

. That is, at time t =

0, t

1

, . . . , t

I

, the stock price as a function of the credit quality is:

S(y(t), t) = e

(r−q)t

S

0

E

Q

[Φ(y(t

I

)) |y(t) ]

E

Q

[Φ(y(t

I

)) |y(0) ]

(2)

The factor

S0

E

Q

[Φ(y(t

I

))|y(0) ]

is included so that S(y(0), 0) has the correct initial value.

Calibration. The credit to equity mapping for all times is characterized by the

univariate function Φ. So that the default state y

−1

of the credit quality variable

corresponds to a zero stock price, the function Φ must satisfy Φ(y

−1

) = 0. From

equation (2) we see that this ensures that S(y

−1

, t) = 0 for all t.

Empirically, we would expect that in most instances an increase in credit quality

will correspond to an increase in equity price. There are, however, exceptions to this

general case. For example, if a ﬁrm issues additional shares, this has a detrimental

eﬀect on stock prices due to dilution, while cash reserves will increase and the

credit quality will improve. The opposite happens in case of a share buy-back. We

consciously ignore these eﬀects and require that the equity price be a monotonic

function of the credit quality at all times. This can be accomplished by restricting

our choice of Φ to be monotonically increasing.

Having tried several alternatives, the method we settled on to specify Φ is to

choose this function so that extreme moves in the equity correspond to a given

drop in credit quality. Typically, EDS contracts pay out when the share price

drops to 30% of its price when the contract is initiated. The approach we followed

is to obtain statistics on the average rating change that occurs when drops of that

magnitude occur in the associated equity, and then choose Φ to match the rating

change for a representative ﬁrm with each initial rating. This method appears to

be numerically robust and provides a reasonable ﬁt also to at-the-money implied

volatilities for equity options. Instead, the strategy of ﬁtting only the latter implied

volatilities alone proved to be more diﬃcult to implement.

Φ is determined non-parametrically. The value of Φ is speciﬁed at a number of

points on the lattice Λ

N

and the values in between are determined using a spline.

Speciﬁcally, for a set of integers k

1

, . . . , k

M

with 0 = k

1

< k

2

< · · · < k

M

= N we

specify the values of Φ(y

k1

), . . . , Φ(y

k

M

). These values are speciﬁed so that 70%

drops in equity price correspond to the desired rating change, for each initial rating.

We choose a set of L initial ratings with initial nodes b

1

, . . . , b

L

∈ {0, . . . , N}.

If the function Φ is speciﬁed, we can use equation (2) to ﬁnd the function S(y, t).

From each initial node b

, we can ﬁnd the closest node c

that corresponds to a

70% decrease in share price after t

I

years as

|S(y

c

, t

I

) −0.3S(y

b

, 0)| = min

0≤i≤N

|S(y

i

, t

I

) −0.3S(y

b

, 0)|

PRICING EQUITY DEFAULT SWAPS 5

Initial Rating Change

Rating at 30%

Caa Caa -0

B2 B3 -1

Ba2 B1 -2

Baa2 Ba2 -3

A2 Baa2 -3

Aa2 A2 -3

Aaa A1 -4

Table 1. The target for calibrating to extreme price movements.

The ﬁrst column contains the seven initial ratings that we calibrate

to. The second column contains the target rating which a 70%

stock price fall corresponds to. The last column is the number of

rating levels between the ﬁrst and second columns.

We specify Φ as a linear spline in order to be able to apply a linear least squares

routine. That is, we consider the values Φ(y

k1

), . . . , Φ(y

k

M

) to be vertices of a

piecewise linear function so that:

Φ(y

j

) =

θ +

M

¸

m=1

(β + α

m

)(y

km+1

−y

km

)1

{j≥km+1}

+ (β + α

m

)(y

kj

−y

km

)1

{km<j<km+1}

.

(3)

Here, θ > 0 is the value of Φ(y

0

), β > 0 is the minimum value that the slopes can

have and β + α

m

are the slope of Φ in the region (y

km

, y

km+1

), with α

m

> 0 for

m = 1, . . . , M. Notice also that

E

Q

[Φ(y

t

I

)|y(0) = y

i

] =

N

¸

j=0

U

0,t

I

(i, j)Φ(y

j

). (4)

Substituting equation (3) into (4), we see that the values 0.3S(y

b

**, 0) are linear func-
**

tions of θ and the slopes α

m

. Thus, if we specify targets for the c

, the problem is

a linear least squares minimisation with non-negative constraints on the dependent

variables θ and α

m

, for m = 1, . . . , M.

As a simple example, we choose seven initial ratings: Aaa, Aa2, A2, Baa2, Ba2,

B2, Caa. The rating migration that corresponds to a 70% drop in share price are

shown in Table 1 and the values for the probability kernel U is taken from Albanese

and Chen (2004). The Φ that leads to these rating migrations is shown in Figure 1.

Notice the pronounced step-like behaviour of Φ. This can be seen as a reﬂection

of the situation where the equity price declines sharply if the associated ﬁrm is

downgraded by the rating agency.

It is instructive to see the local volatility function that is implied by this choice

of Φ. In the discrete state case, the analog to the local volatility function is the

6 CLAUDIO ALBANESE AND OLIVER CHEN

Figure 1. The function Φ labelled by t = 5 that gives rise to the

rating migrations shown in Table 1. The lines labelled by t = 3 and

t = 1 are E

Q

[Φ(y(5)) |y(3) ] and E

Q

[Φ(y(5)) |y(1) ], respectively.

When the three are multiplied by

S0

E

Q

[Φ(y(5))|y(0) ]

, we obtain the

stock price as a function of credit quality for ﬁve, three and one

years.

quantity:

E

Q

(S(y(t + ∆t), t + ∆t) −S(y(t), t))

2

|y(t)

S(y(t), t)∆t

, (5)

which for a diﬀusion process is equal to the local volatility function in the limit

∆t → 0. The plot of equation (5) is given in Figure 2, when the function Φ is

given by Figure 1. We see that it can be well approximated by the negative power

function σ(S) = ¯ σS

−0.65

. This property is far from obvious and suggests that a

simple pure diﬀusion approximation to the equity process would correspond to a

CEV speciﬁcation of local volatility σ(S) = ¯ σS

−β

.

3. Pricing an EDS

We describe the pricing of a standard EDS. Our representative EDS has a no-

tional amount of $1 and requires semi-annual payments of w

EDS

/2 until either the

contract expires at maturity T, or there is a ‘equity default event’ of the stock price

reaching 30% of the price when the EDS was struck. If an equity default event

occurs, one last payment is made, equal to the accrued value of the payment from

the last full payment. And, a payout is made to the protection buyer of an amount

equal to one half the notional. The initial credit quality of the issuer of the equity

is y

j

.

PRICING EQUITY DEFAULT SWAPS 7

Figure 2.

Once we have speciﬁed a model for the stopping time corresponding to events of

equity default, EDS contracts can be priced similarly to CDSs. The swap rate of

an EDS is that rate for which the expected present value of payments is equal to

the expected present value of payouts, so that the contract is at equilibrium. For

ease of notation, we assume that payments occur with semi-annual frequency, and

that the maturity T is an integer number of years. These two restrictions can be

easily generalised.

Then, it can be shown in this discrete time setting that the swap rate s

EDS

is:

s

EDS

=

¸

I

i=1

ˆ q

CBM

(t

i

)e

−rti

1 −

¸

I

i=1

ˆ q

CBM

(t

i

)

¸

2T

i=1

e

−ri/2

+

¸

I

i=1

ˆ q

CBM

(t

i

)

¸

2t

∗

i

=1

e

−r/2

+ 2(t

i

−t

∗

i

)e

−rti

(6)

where t

∗

i

is the last payment date before t

i

, ˆ q

CBM

(t

i

) is the probability of equity

default occurring at time t

i

, with the dependency on the initial credit rating j

suppressed. To calculate this probability, let L = 0.3S

0

be the barrier level at which

the EDS pays out. Then, on the discretised time lattice {t

0

= 0, t

1

, . . . , t

I

= T}

and under the risk-neutral measure Q, the probability of equity default occurring

at time t

i

is:

ˆ q

CBM

(t

i

) =

ji−1

¸

i=−1

N

¸

i−1=ji−1

· · ·

N

¸

1=j1

U

t0,t1

(j,

1

) . . . U

ti−1,ti

(

i−1

,

i

)

where the j

i

are such that

S(x

ji−1

, t

i

) ≤ L

S(x

ji

, t

i

) > L

8 CLAUDIO ALBANESE AND OLIVER CHEN

Figure 3. EDS rates for various initial credit ratings calculated

using equation (6) and the function Φ shown in Figure 1

.

Numerical example. For the numerical example, we use a constant interest rate

of 5% and a constant dividend yield of 3%. Using equation (6) with the function Φ

shown in Figure 1 to specify the credit to equity mapping, the EDS rates calculated

from the credit barrier model are shown in Figure 3. The CDS rates calculated from

the credit barrier model as a percentage of the EDS rates are shown in Figure 4. We

ﬁnd that for high rated issues, the ratio of EDS to CDS spreads is about 2:1 while

for low rated issues the same ratio is about 10:9. This compares to corresponding

market ratios that typically range from 5:1 to 10:1, and can be as high as 20:1. See

Figure 5, which plots the EDS spread against the CDS spread for ﬁrms in the DJ

Europe Stoxx 50.

The reason why our EDS rates are so low relative to CDS rates is due to the

presence of jumps in the credit barrier model. Since the default boundary is ab-

sorbing and jumps are added by subordinating on a gamma process, there is the

possibility of jump to default.

For the sake of comparison, we also examine a pure diﬀusion equity model in

which zero is an absorbing state. The local volatility shown in Figure 2 which is

given by the credit barrier model and the credit to equity mapping speciﬁed by the

Φ shown in Figure 1 can be approximated by ¯ σS

−0.65

. This suggests that a pure

diﬀusion approximation to the credit barrier model would be a stock price that

follows a CEV process. In the next section, we elaborate on this model.

4. Pricing with a CEV model with absorption

S

t

is said to be a constant elasticity of variance (CEV) process if it solves the

stochastic diﬀerential equation:

dS

t

= µS

t

dt + ¯ σS

β+1

t

dW

t

, (7)

PRICING EQUITY DEFAULT SWAPS 9

Figure 4. CDS rates as a percentage of EDS rates in Figure 3.

Figure 5. EDS spreads plotted against CDS spreads for ﬁrms in

the Europe Stoxx 50 on August 4, 2004. The dotted lines are the

lines of constant EDS to CDS spread ratio. Data courtesy of JP

Morgan.

10 CLAUDIO ALBANESE AND OLIVER CHEN

where W

t

is standard Brownian motion, ¯ σ > 0 and β is unrestricted. This process

was originally introduced into the ﬁnancial literature by Cox (1975). The geometric

Brownian motion asset price process of Black and Scholes (1973) is obtained with

the special case β = 0 and the square-root process of Cox and Ross (1976) is

obtained with β = −

1

2

.

Under the risk-neutral measure Q

CEV

, we have µ = r −q, where r is the risk-free

rate and q the continuously compounded dividend yield.

The local volatility of the CEV process is σ(S) = ¯ σS

β

. Due to the shape of the

local volatility function for the credit barrier model with credit to equity mapping

found in Figure 2, we focus on the case β < 0. Furthermore, from the boundary

classiﬁcation the CEV process has absorption at zero only for β < 0. Thus, the

case β ≥ 0 is not of interest for our purposes. Henceforth, all results and formulae

will be presented for the case β < 0 only.

To calibrate the CEV equity process to price EDS contracts, we give formulae

for the price of a European call and the CDS rate for an equity price that follows a

CEV process. Thus, given an implied volatility (for say, a maturity of one year and

at-the-money strike) and a CDS rate, we will be able to specify the parameters β

and ¯ σ that reproduce these. With these, we can ﬁnd the EDS rate.

Call price. Cox (1975) gives the European call price for a stock that follows a CEV

process as:

C(S

0

; K, T) = S

0

e

−qT

Q(y(K, T); η, ζ(S

0

, T)) −e

−rT

K(1 −Q(ζ(S

0

, T); η −2, y(K, T)))

(8)

where T is the maturity, K is the strike, Q(x; u, v) is the complementary noncen-

tral chi-square distribution function with u degrees of freedom and non-centrality

parameter v and

η = 2 +

1

|β|

,

ζ(S

0

, T) =

2µS

−2β

0

¯ σ

2

β(e

2µβT

−1)

, (9)

y(K, T) =

2µK

−2β

¯ σ

2

β(1 −e

−2µβT

)

.

CDS rate. With the stock price following a CEV diﬀusion, the stopping time τ for

credit defaults is

τ = inf(t > 0 : S

t

= 0).

Thus, in order to ﬁnd the CDS rate, we require the probability of absorption at

zero of the stock price process.

The swap rate s

CDS

of a CDS is

s

CDS

=

2

T

0

q

CEV

(τ)e

−rτ

1 −

ˆ

R −

ˆ

R(τ −τ

∗

)C

dτ

(1 −Q

CEV

(T))

¸

2T

i=1

e

−ri/2

+

T

0

q

CEV

(τ)

¸

2τ

∗

i=1

e

−ri/2

+ 2(τ −τ

∗

)e

−rτ

dτ

(10)

where

ˆ

R is the risk-neutral recovery rate and C is the coupon of the underlying bond

as a fraction of the face, τ

∗

is the last CDS payment date before default occurring

PRICING EQUITY DEFAULT SWAPS 11

at τ, Q

CEV

(t) is the probability of having defaulted by time t and q

CEV

(t) is

the density of the probability of default. For the notation of both Q

CEV

(t) and

q

CEV

(t), the dependency on the starting point S

0

has been suppressed.

The probability Q

CEV

(t) for a default occurring by time t is given in Cox (1975)

as

Q

CEV

(t) = Q

CEV

(S

t

= 0|S

0

)

= 1 −Γ

ν,

ζ(S

0

, t)

2

,

where ζ is given by (9), ν =

1

2|β|

and Γ(·, ·) is the incomplete gamma function.

Then, the density q

CEV

(t) of the probability of default is just the derivative of

Q

CEV

(t):

q

CEV

(t) =

βµζ(S

0

, t)

ν

e

−ζ(S0,t)/2

2

ν−1

Γ(ν)(1 −e

−2µβt

)

.

Here, Γ(·) is the usual gamma function.

EDS rate. In analogy to the discrete time setting given in the previous section, in

a continuous time model the swap rate s

EDS

of an EDS is:

s

EDS

=

T

0

ˆ q

CEV

(ˆ τ)e

−rt

dˆ τ

1 −

ˆ

Q

CEV

(T)

¸

2T

i=1

e

−ri/2

+

T

0

ˆ q

CEV

(ˆ τ)

¸

2ˆ τ

∗

i=1

e

−ri/2

+ 2(ˆ τ − ˆ τ

∗

)e

−rˆ τ

dˆ τ

(11)

where ˆ τ

∗

is the last EDS payment date before equity default occurring at ˆ τ with

ˆ τ = inf(t > 0 : S

t

≤ L),

where L is the level at which the payout of the EDS is triggered, typically 30% of

the initial stock price. Also,

ˆ

Q

CEV

(t) is the probability of equity default having

occurred by time t and ˆ q

CEV

(t) is the density of the probability of equity default.

Again, for the notation of

ˆ

Q

CEV

(t) and ˆ q

CEV

(t) the dependency on the starting

point S

0

is suppressed.

Thus, in order to compute the swap rate for an EDS of a stock following a CEV

process using equation (11) we need to compute

ˆ

Q

CEV

(t). Once this is obtained,

ˆ q

CEV

(t) is taken as the derivative of

ˆ

Q

CEV

(t) and (11) can be computed. Now,

ˆ

Q

CEV

(t) = Q

CEV

(ˆ τ < t|S

0

)

= E

1

{ˆ τ<t}

|S

0

(12)

This probability is related to the rebate option given by Davydov and Linetsky

(2003) and can be calculated as:

E

1

{ˆ τ<t}

|S

0

=

S

β+

1

2

0

e

x(S0)

L

β+

1

2

e

x(L)

W

(1+

1

2β

),m

(x(S

0

))

W

(1+

1

2β

),m

(x(L))

−

∞

¸

n=1

2|µβ|W

kn,m

(x(S

0

))e

λnt

λ

n

∂W

k,m

(x(L))

∂k

k=kn

¸

¸

¸.

(13)

12 CLAUDIO ALBANESE AND OLIVER CHEN

Figure 6. CDS rates as a percentage of EDS rates. The EDS

rates were calculated using equation (13) for the CEV process.

Here,

= −

1

2

sign(µ) (14)

m =

−1

4β

(15)

x(S) = −

|µ|

¯ σ

2

β

S

−2β

(16)

and k

n

is the n

th

root of W

k,m

(x(L)) = 0 and

λ

n

= 2|µ|β [k

n

+ (2m−1)] (17)

In equation (13), the function W

k,m

(x) is the Whittaker function.

In practice, the roots k

n

are computed numerically and the derivative terms in

equation (13) are also computed numerically as there is no simple analytic formula

for them. Then, using equation (13) for the function

ˆ

Q

CEV

, we can compute

ˆ q

CEV

as the numerical derivative of

ˆ

Q

CEV

and both of these functions are used to

calculate the EDS rate for a CEV process, using equation (11).

Again with an interest rate of 5% and a dividend yield of 3%, using β and ¯ σ such

that the CDS rates match those from the credit barrier model and the one year

at-the-money implied volatilities are an increasing function of the credit rating, we

obtain Figure 6. We ﬁnd that the ratios found using the CEV equity model are

much closer to those found in market EDS and CDS spreads.

5. Conclusion

The ratio of EDS rates to CDS rates found in the CEV model vary from about

8:1 at the high ratings to about 2:1 in the low ratings These are in the range of

PRICING EQUITY DEFAULT SWAPS 13

current market ratios. On the other hand, the credit barrier model which includes

jumps and is consistent with historical default and migration probabilities gives

rise to ratios substantially closer to 1:1. We thus conclude that EDS contracts are

currently being priced using pure diﬀusion processes with state dependent volatility

and that the risk of credit jumps and jump to default is not priced.

A number of issues remain open though as our analysis is based on a number

of assumption. The strongest ones are that there is only one factor driving both

the credit and the equity process and we neglect information about economic cy-

cles by calibrating to through-the-cycle rating transition probabilities. The extra

randomness coming from the cycle indicators are captured in a stylized fashion by

the jump model component. One could wonder whether a two factor model cal-

ibrated to point-in-time information would yield instead diﬀerent results. Given

that EDS contracts are typically struck with long maturities of about 5 years, intu-

ition would suggest that cycle eﬀect would not have a major impact on EDS/CDS

ratios, although a more accurate analysis of this point would be useful.

References

Albanese, C., J. Campolieti, O. Chen and A. Zavidonov (2003), ‘Credit barrier models’, Risk

16(6).

Albanese, C. and O. Chen (2004), Discrete credit barrier models. Working paper, available at:

http://www.ma.ic.ac.uk/ calban.

Black, F. and M. Scholes (1973), ‘The pricing of options and corporate liabilities’, Journal of

Political Economy 81(3), 637–54.

Cox, J. (1975), Notes on option pricing I: constant elasticity of variance diﬀusions. Working paper,

Stanford University (reprinted in Journal of Portfolio Management, 1996, 22, 15–17.).

Cox, J. and S. Ross (1976), ‘The valuation of options for alternative stochastic processes’, Journal

of Financial Economics 3, 145–166.

Davydov, D. and V. Linetsky (2003), ‘Pricing options on scalar diﬀusions: an eigenfunction ex-

pansion approach’, Operations research 51(2), 185–209.

Claudio Albanese, Department of Mathematics, Imperial College, London, U.K.

E-mail address: claudio.albanese@imperial.ac.uk

Oliver Chen, Department of Mathematics, University of Toronto, Toronto, Canada

E-mail address: ochen@math.toronto.edu

Once mapped into an equity option model. Besides the volatility. In the case of EDS contracts however. a second issue is the presence of jumps. It was shown that under the statistical measure. combined with a new technique for credit-equity mapping designed to price creditequity hybrids. the magnitude of the drop in share price needed to trigger the payout of an EDS will likely occur concurrently with a deterioration in the credit rating of the ﬁrm. The point of view we take in this paper is that in order to properly specify a model for EDS contracts one should calibrate to aggregate data for ﬁrms across all credit ratings to ensure that the model remains consistent if a drastic drop in equity price occurs. It is our opinion that cycle dependencies are an important but secondary eﬀect which can be taken into account by a reﬁnement of the model. we use a credit quality to equity price mapping on top of the credit barrier model so that the information in the credit markets is imparted into the equity process. The challenge from the pricing viewpoint is to determine the fair value for the ratio between CDS and EDS spreads and thus suitable replication strategies. The diﬀerence between model and market rates can be explained by ﬁnancially meaningful forward liquidity spreads. In turn. implying major changes in the capital structure of the ﬁrm. In fact. In this paper. We thus compare EDS prices obtained with . the presence of jumps increase the CDS spread to EDS spread ratio to approach 100%. EDS contracts are structured as far outof-the-money American digitals with payments in semiannual installments. In credit models for credit default swaps. In order to price EDS contracts. The standard market practice for barrier options would be to use a local volatility model calibrated to European options. In this paper we attempt to quantify the diﬀerence using the credit barrier models introduced in Albanese. the practice is questionable due to the extreme out of the money character of the strike. This is a common feature of all credit models which has substantial repercussions on the size of EDS spreads. as opposed to point-in-time rating systems such as expected default frequencies. this can lead to quite diﬀerent values for implied volatilities and a modiﬁcation of the corresponding implied volatility process. the model spread rates in the pricing measure are in good agreement with market aggregate spread rates. convertible bonds and credit baskets it is customary to include jumps. but this would add technical complexities which there is merit to avoid in a ﬁrst approximation. historical averages of rating transition and default probabilities can be replicated with accuracy across all rating classes. In the version of Albanese et al. we ﬁnd that this ratio is quite sensitive to the modeling assumptions. credit barrier models for the credit quality process are calibrated to market data in both the statistical and pricing measures. except that jumps need to be present in the process to achieve consistency with historical transition probabilities. Chen and Zavidonov (2003) and Albanese and Chen (2004). Campolieti.2 CLAUDIO ALBANESE AND OLIVER CHEN Another typical trade is to enhance the yield of synthetic collateralized debt obligations (CDOs) by creating pockets of EDS positions or even creating a synthetic equity collateralized obligation (ECO) by a portfolio of only EDS contracts. Upon applying a risk-neutralizing drift. From the equity modeling viewpoint. Qualitatively. (2003). we make use of through-the-cycle ratings. In this analysis. we ﬁnd that our calibrated credit barrier model leads to a local volatility proﬁle quite similar to a CEV speciﬁcation.

tj (m. . and (ii) by calibrating a CEV local volatility pure diﬀusion model with absorption at zero to single name at-the-money implied equity option volatilities and CDS spreads. we describe here in detail the construction of the credit-to-equity mapping. For a given debt-issuer which is also a publicly traded company. tI . Since credit quality is not a tradeable asset. at time t = 0 we let the initial stock price be S0 and the initial credit quality be y(0). The parameters for the speciﬁcation of the pricing measure Q are obtained by calibrating against aggregate corporate bond prices. . To reconcile the statistical with the pricing information. Instead. the three market makers would act the same way. we have an absorbing state y−1 which we consider to be the state of default and for which we have the probabilities of default: Uti . We wish to specify the equity process S(t) as a function of the credit quality y(t) for t = t1 . Comparing with market quotes. Section 5 concludes. The kernel of transition probabilities on the lattice ΛN and on the discrete time lattice is denoted by: Uti . n) = Q (y(tj ) = yn |y(ti ) = ym ) 0 ≤ i ≤ j ≤ I. one is led to construct one factor models where equity is deterministically linked to credit quality. Credit quality to equity mapping As explained in the introduction. 0 ≤ m ≤ N. namely credit transition probabilities. n ≤ N. Section 4 prices EDS contracts using a pure diﬀusion process of CEV type with defaults. the credit quality process need not be a martingale process even in the pricing measure. taxation and liquidity spreads. The article is organized as follows: section 2 gives the speciﬁcation of the credit to equity mapping and describes the calibration procedure.tj (m. . Let tI = I∆t be the date up to which we need to generate the credit quality and equity processes. the market price of credit risk is estimated and yield spreads are disentangled into a sum of credit. Referring to our previous papers Albanese et al. (2003) and Albanese and Chen (2004) for a description of the mathematical framework and calibration issues. Deﬁne a credit quality variable y which can take values on a discrete lattice of points ΛN = {yn }N with time restricted to a discrete set of points ti = i∆t where n=0 ∆t is a ﬁxed time interval such as one quarter. historical default probabilities and average credit default swap spreads in the investment grade sectors. There is no a-priori reason why these three shocks should be driven by a single factor. However. It is challenging to ﬁt together in a comprehensive framework the three interacting shocks coming from the CDS market making. the stock market making and the volatility market making. 2. In addition. we ﬁnd that the ratio of EDS to CDS spreads can be as large as 8:1. Using the CEV model. However. 0 ≤ m. one would expect that conditioned to a rare event such as equity or credit default occurring. We then price EDS contracts in section 3. credit barrier models are calibrated to aggregate data. in order to avoid arbitrage opportunities the discounted equity process e−(r−q)t S(t) must be a . a credit barrier model including jumps can only be consistent with ratios of at most 2:1. Assuming conditional collinearity of the relevant shocks. . we conclude that currently jumps do not appear to be priced.PRICING EQUITY DEFAULT SWAPS 3 two procedures: (i) by using the credit barrier model with jumps and a credit to equity map. −1) = Q (y(tj ) = y−1 |y(ti ) = ym ) 0 ≤ i ≤ j ≤ I.

3S(yb . For the equity prices at times ti previous to maturity. Having tried several alternatives. . N }. So that the default state y−1 of the credit quality variable corresponds to a zero stock price. 0) has the correct initial value. This can be accomplished by restricting our choice of Φ to be monotonically increasing. 0)| = 0≤i≤N min |S(yi . To ensure that equation (1) is satisﬁed. we can specify the credit quality to equity mapping at maturity tI by a univariate function Φ. . . From each initial node b . . Φ(ykM ). From equation (2) we see that this ensures that S(y−1 . tI ) − 0. For example. Empirically. and then choose Φ to match the rating change for a representative ﬁrm with each initial rating. Φ is determined non-parametrically. . If the function Φ is speciﬁed. The approach we followed is to obtain statistics on the average rating change that occurs when drops of that magnitude occur in the associated equity. exceptions to this general case. t). . for each initial rating. tI . . . 0)| . the strategy of ﬁtting only the latter implied volatilities alone proved to be more diﬃcult to implement. Calibration. We choose a set of L initial ratings with initial nodes b1 . kM with 0 = k1 < k2 < · · · < kM = N we specify the values of Φ(yk1 ). The credit to equity mapping for all times is characterized by the univariate function Φ. . . The value of Φ is speciﬁed at a number of points on the lattice ΛN and the values in between are determined using a spline.3S(yb . We consciously ignore these eﬀects and require that the equity price be a monotonic function of the credit quality at all times. . . where r is the risk-free rate and q is the continuously compounded dividend yield. EDS contracts pay out when the share price drops to 30% of its price when the contract is initiated. if a ﬁrm issues additional shares. Speciﬁcally. we require that: (1) EQ e−(r−q)tj S(ti + tj ) |S(ti ) = S(ti ) where 0 ≤ i ≤ I and 0 ≤ j ≤ I − i. Typically. . . . the function Φ must satisfy Φ(y−1 ) = 0. both of which we assume to be constant. bL ∈ {0. we compound the expectation of Φ conditional to the credit quality at ti . These values are speciﬁed so that 70% drops in equity price correspond to the desired rating change. tI ) − 0. while cash reserves will increase and the credit quality will improve. That is. at time t = 0. this has a detrimental eﬀect on stock prices due to dilution. . There are. t) = 0 for all t. . however. we can use equation (2) to ﬁnd the function S(y. This method appears to be numerically robust and provides a reasonable ﬁt also to at-the-money implied volatilities for equity options. Speciﬁcally. t) S0 EQ [Φ(y(tI ))|y(0) ] = e(r−q)t S0 EQ [Φ(y(tI )) |y(t) ] EQ [Φ(y(tI )) |y(0) ] is included so that S(y(0). the method we settled on to specify Φ is to choose this function so that extreme moves in the equity correspond to a given drop in credit quality. we can ﬁnd the closest node c that corresponds to a 70% decrease in share price after tI years as |S(yc . we would expect that in most instances an increase in credit quality will correspond to an increase in equity price.4 CLAUDIO ALBANESE AND OLIVER CHEN martingale process in the pricing measure. for a set of integers k1 . . The opposite happens in case of a share buy-back. . Instead. t1 . . the stock price as a function of the credit quality is: (2) The factor S(y(t).

Ba2. . We specify Φ as a linear spline in order to be able to apply a linear least squares routine. .tI (i. Thus. . In the discrete state case. with αm > 0 for m = 1. .3S(yb . A2. The second column contains the target rating which a 70% stock price fall corresponds to. M . the analog to the local volatility function is the . j)Φ(yj ). The Φ that leads to these rating migrations is shown in Figure 1. . we choose seven initial ratings: Aaa. ykm+1 ). The last column is the number of rating levels between the ﬁrst and second columns. The target for calibrating to extreme price movements. . That is. β > 0 is the minimum value that the slopes can have and β + αm are the slope of Φ in the region (ykm . . we see that the values 0. It is instructive to see the local volatility function that is implied by this choice of Φ. . (3) Here. if we specify targets for the c . Φ(ykM ) to be vertices of a piecewise linear function so that: Φ(yj ) = M θ+ m=1 (β + αm )(ykm+1 − ykm )1{j≥km+1 } + (β + αm )(ykj − ykm )1{km <j<km+1 } . . Notice also that N (4) EQ [Φ(ytI )|y(0) = yi ] = j=0 U0. As a simple example. the problem is a linear least squares minimisation with non-negative constraints on the dependent variables θ and αm . The ﬁrst column contains the seven initial ratings that we calibrate to. Substituting equation (3) into (4). This can be seen as a reﬂection of the situation where the equity price declines sharply if the associated ﬁrm is downgraded by the rating agency. Caa. The rating migration that corresponds to a 70% drop in share price are shown in Table 1 and the values for the probability kernel U is taken from Albanese and Chen (2004). Baa2. θ > 0 is the value of Φ(y0 ). . Aa2. B2. . we consider the values Φ(yk1 ).PRICING EQUITY DEFAULT SWAPS 5 Initial Rating Change Rating at 30% Caa Caa -0 B2 B3 -1 Ba2 B1 -2 Baa2 Ba2 -3 A2 Baa2 -3 Aa2 A2 -3 Aaa A1 -4 Table 1. 0) are linear functions of θ and the slopes αm . M . . for m = 1. Notice the pronounced step-like behaviour of Φ.

three and one years.65 . ¯ 3. The lines labelled by t = 3 and t = 1 are EQ [Φ(y(5)) |y(3) ] and EQ [Φ(y(5)) |y(1) ]. S0 When the three are multiplied by EQ [Φ(y(5))|y(0) ] . This property is far from obvious and suggests that a ¯ simple pure diﬀusion approximation to the equity process would correspond to a CEV speciﬁcation of local volatility σ(S) = σ S −β . 2 which for a diﬀusion process is equal to the local volatility function in the limit ∆t → 0. The initial credit quality of the issuer of the equity is yj .6 CLAUDIO ALBANESE AND OLIVER CHEN Figure 1. equal to the accrued value of the payment from the last full payment. a payout is made to the protection buyer of an amount equal to one half the notional. one last payment is made. Pricing an EDS We describe the pricing of a standard EDS. t)∆t . The plot of equation (5) is given in Figure 2. t + ∆t) − S(y(t). The function Φ labelled by t = 5 that gives rise to the rating migrations shown in Table 1. Our representative EDS has a notional amount of $1 and requires semi-annual payments of wEDS /2 until either the contract expires at maturity T . And. If an equity default event occurs. quantity: EQ (S(y(t + ∆t). we obtain the stock price as a function of credit quality for ﬁve. We see that it can be well approximated by the negative power function σ(S) = σ S −0. respectively. when the function Φ is given by Figure 1. t)) |y(t) (5) S(y(t). or there is a ‘equity default event’ of the stock price reaching 30% of the price when the EDS was struck. .

ti ( i−1 . Once we have speciﬁed a model for the stopping time corresponding to events of equity default. For ease of notation. so that the contract is at equilibrium. . . . . Then. Then. 1 ) . we assume that payments occur with semi-annual frequency. Uti−1 . i ) where the ji are such that S(xji −1 . t1 .t1 (j. These two restrictions can be easily generalised. and that the maturity T is an integer number of years.3S0 be the barrier level at which the EDS pays out.PRICING EQUITY DEFAULT SWAPS 7 Figure 2. qCBM (ti ) is the probability of equity ˆ i default occurring at time ti . ti ) > L . . with the dependency on the initial credit rating j suppressed. To calculate this probability. on the discretised time lattice {t0 = 0. EDS contracts can be priced similarly to CDSs. the probability of equity default occurring at time ti is: ji −1 N N I ˆ i=1 qCBM (ti ) I −rti ˆ i=1 qCBM (ti )e 2T I −ri/2 + ˆ i=1 e i=1 qCBM (ti ) 2t∗ −r /2 i =1 e + 2(ti − t∗ )e−rti i qCBM (ti ) = ˆ i =−1 i−1 =ji−1 ··· 1 =j1 Ut0 . it can be shown in this discrete time setting that the swap rate sEDS is: sEDS = 1− (6) where t∗ is the last payment date before ti . The swap rate of an EDS is that rate for which the expected present value of payments is equal to the expected present value of payouts. let L = 0. ti ) ≤ L S(xji . tI = T } and under the risk-neutral measure Q. .

the ratio of EDS to CDS spreads is about 2:1 while for low rated issues the same ratio is about 10:9.8 CLAUDIO ALBANESE AND OLIVER CHEN Figure 3. the EDS rates calculated from the credit barrier model are shown in Figure 3. We ﬁnd that for high rated issues. we elaborate on this model.65 . For the sake of comparison. and can be as high as 20:1. See Figure 5. The reason why our EDS rates are so low relative to CDS rates is due to the presence of jumps in the credit barrier model. we also examine a pure diﬀusion equity model in which zero is an absorbing state. ¯ β+1 . For the numerical example. which plots the EDS spread against the CDS spread for ﬁrms in the DJ Europe Stoxx 50. Pricing with a CEV model with absorption St is said to be a constant elasticity of variance (CEV) process if it solves the stochastic diﬀerential equation: (7) dSt = µSt dt + σ St dWt . 4. there is the possibility of jump to default. This compares to corresponding market ratios that typically range from 5:1 to 10:1. This suggests that a pure ¯ diﬀusion approximation to the credit barrier model would be a stock price that follows a CEV process. In the next section. we use a constant interest rate of 5% and a constant dividend yield of 3%. The local volatility shown in Figure 2 which is given by the credit barrier model and the credit to equity mapping speciﬁed by the Φ shown in Figure 1 can be approximated by σ S −0. Using equation (6) with the function Φ shown in Figure 1 to specify the credit to equity mapping. The CDS rates calculated from the credit barrier model as a percentage of the EDS rates are shown in Figure 4. EDS rates for various initial credit ratings calculated using equation (6) and the function Φ shown in Figure 1 . Since the default boundary is absorbing and jumps are added by subordinating on a gamma process. Numerical example.

Figure 5. CDS rates as a percentage of EDS rates in Figure 3.PRICING EQUITY DEFAULT SWAPS 9 Figure 4. EDS spreads plotted against CDS spreads for ﬁrms in the Europe Stoxx 50 on August 4. . Data courtesy of JP Morgan. The dotted lines are the lines of constant EDS to CDS spread ratio. 2004.

The swap rate sCDS of a CDS is 2 sCDS = (1 − QCEV (T )) (10) ˆ where R is the risk-neutral recovery rate and C is the coupon of the underlying bond as a fraction of the face. K is the strike. all results and formulae will be presented for the case β < 0 only. T ) = S0 e−qT Q(y(K. σ 2 β(e2µβT − 1) ¯ 2µK −2β . where r is the risk-free rate and q the continuously compounded dividend yield. ¯ Call price. T ) = = −2β 2µS0 . σ > 0 and β is unrestricted. σ 2 β(1 − e−2µβT ) ¯ CDS rate. T ). we require the probability of absorption at zero of the stock price process. we focus on the case β < 0. ζ(S0 . τ ∗ is the last CDS payment date before default occurring T 0 ˆ ˆ qCEV (τ )e−rτ 1 − R − R(τ − τ ∗ )C dτ + T 0 2T −ri/2 i=1 e qCEV (τ ) 2τ ∗ −ri/2 i=1 e + 2(τ − τ ∗ )e−rτ dτ . T ))) (8) where T is the maturity. Henceforth. T )) − e−rT K(1 − Q(ζ(S0 . a maturity of one year and at-the-money strike) and a CDS rate. the case β ≥ 0 is not of interest for our purposes. Furthermore. we will be able to specify the parameters β and σ that reproduce these. Thus. With these. we have µ = r − q. T ). The local volatility of the CEV process is σ(S) = σ S β . the stopping time τ for credit defaults is τ = inf(t > 0 : St = 0).10 CLAUDIO ALBANESE AND OLIVER CHEN where Wt is standard Brownian motion. y(K. K. Cox (1975) gives the European call price for a stock that follows a CEV process as: C(S0 . 2 Under the risk-neutral measure QCEV . from the boundary classiﬁcation the CEV process has absorption at zero only for β < 0. η. To calibrate the CEV equity process to price EDS contracts. u. we give formulae for the price of a European call and the CDS rate for an equity price that follows a CEV process. This process ¯ was originally introduced into the ﬁnancial literature by Cox (1975). The geometric Brownian motion asset price process of Black and Scholes (1973) is obtained with the special case β = 0 and the square-root process of Cox and Ross (1976) is obtained with β = − 1 . T ) y(K. Due to the shape of the ¯ local volatility function for the credit barrier model with credit to equity mapping found in Figure 2. Thus. in order to ﬁnd the CDS rate. we can ﬁnd the EDS rate. v) is the complementary noncentral chi-square distribution function with u degrees of freedom and non-centrality parameter v and 1 . given an implied volatility (for say. η − 2. Q(x. η = 2+ |β| (9) ζ(S0 . Thus. With the stock price following a CEV diﬀusion.

EDS rate.m (x(L)) 2 L n=1 λn ∂k k=kn (13) . 2ν−1 Γ(ν)(1 − e−2µβt ) Here. 2 1 where ζ is given by (9). QCEV (t) is the probability of equity default having occurred by time t and qCEV (t) is the density of the probability of equity default. T 0 qCEV (ˆ)e−rt dˆ ˆ τ τ T 0 ˆ 1 − QCEV (T ) 2T −ri/2 i=1 e + qCEV (ˆ) ˆ τ 2ˆ∗ −ri/2 τ i=1 e τ + 2(ˆ − τ ∗ )e−rˆ dˆ τ ˆ τ where L is the level at which the payout of the EDS is triggered. in a continuous time model the swap rate sEDS of an EDS is: sEDS = (11) where τ ∗ is the last EDS payment date before equity default occurring at τ with ˆ ˆ τ = ˆ inf(t > 0 : St ≤ L). Thus. Once this is obtained. t)ν e−ζ(S0 . typically 30% of ˆ the initial stock price. in order to compute the swap rate for an EDS of a stock following a CEV ˆ process using equation (11) we need to compute QCEV (t). τ β+ 1 e x(L) ∂Wk.m (x(S0 ))e E 1{ˆ<t} |S0 = − . Then. the dependency on the starting point S0 has been suppressed. The probability QCEV (t) for a default occurring by time t is given in Cox (1975) as QCEV (t) = QCEV (St = 0|S0 ) ζ(S0 .m (x(L)) 1 W (1+ 2β ). t) .m (x(S0 )) S0 e 2|µβ|Wkn . for the notation of QCEV (t) and qCEV (t) the dependency on the starting ˆ point S0 is suppressed. ˆ CEV (t) and (11) can be computed. In analogy to the discrete time setting given in the previous section. Now. qCEV (t) is taken as the derivative of Q ˆ ˆ QCEV (t) (12) = QCEV (ˆ < t|S0 ) τ = E 1{ˆ<t} |S0 τ This probability is related to the rebate option given by Davydov and Linetsky (2003) and can be calculated as: 1 β+ 2 x(S0 ) ∞ λn t 1 W (1+ 2β ). Γ(·) is the usual gamma function. QCEV (t) is the probability of having defaulted by time t and qCEV (t) is the density of the probability of default. ˆ ˆ Again. ν = 2|β| and Γ(·.t)/2 . ·) is the incomplete gamma function. = 1 − Γ ν. Also. the density qCEV (t) of the probability of default is just the derivative of QCEV (t): qCEV (t) = βµζ(S0 .PRICING EQUITY DEFAULT SWAPS 11 at τ . For the notation of both QCEV (t) and qCEV (t).

In practice. Then. We ﬁnd that the ratios found using the CEV equity model are much closer to those found in market EDS and CDS spreads. using β and σ such ¯ that the CDS rates match those from the credit barrier model and the one year at-the-money implied volatilities are an increasing function of the credit rating. the roots kn are computed numerically and the derivative terms in equation (13) are also computed numerically as there is no simple analytic formula ˆ for them.m (x(L)) = 0 and (17) In equation (13). we can compute ˆ CEV and both of these functions are used to qCEV as the numerical derivative of Q ˆ calculate the EDS rate for a CEV process. Here. the function Wk.12 CLAUDIO ALBANESE AND OLIVER CHEN Figure 6. CDS rates as a percentage of EDS rates. Again with an interest rate of 5% and a dividend yield of 3%. 5. Conclusion The ratio of EDS rates to CDS rates found in the CEV model vary from about 8:1 at the high ratings to about 2:1 in the low ratings These are in the range of .m (x) is the Whittaker function. we obtain Figure 6. (14) (15) (16) 1 = − sign(µ) 2 −1 m = 4β |µ| x(S) = − 2 S −2β σ β ¯ λn = 2|µ|β [kn + (2m − 1)] and kn is the nth root of Wk. using equation (11). using equation (13) for the function QCEV . The EDS rates were calculated using equation (13) for the CEV process.

and M. University of Toronto. O. ‘The valuation of options for alternative stochastic processes’. J. Canada E-mail address: ochen@math. Working paper. Claudio Albanese. London. and V. available at: http://www. Chen and A. and O. A number of issues remain open though as our analysis is based on a number of assumption. Given that EDS contracts are typically struck with long maturities of about 5 years. C. References Albanese. ‘The pricing of options and corporate liabilities’.ac.K. 185–209. Davydov. Journal of Financial Economics 3. Notes on option pricing I: constant elasticity of variance diﬀusions.ic..). J. Risk 16(6). 15–17.PRICING EQUITY DEFAULT SWAPS 13 current market ratios.ac. Albanese. 145–166.edu . Imperial College. Working paper. Campolieti. The extra randomness coming from the cycle indicators are captured in a stylized fashion by the jump model component. Scholes (1973). We thus conclude that EDS contracts are currently being priced using pure diﬀusion processes with state dependent volatility and that the risk of credit jumps and jump to default is not priced.toronto. Department of Mathematics. D. ‘Credit barrier models’. although a more accurate analysis of this point would be useful. Toronto.ma. Ross (1976). F. C. Cox. Cox.albanese@imperial. 1996. Department of Mathematics. the credit barrier model which includes jumps and is consistent with historical default and migration probabilities gives rise to ratios substantially closer to 1:1. Chen (2004). Linetsky (2003). intuition would suggest that cycle eﬀect would not have a major impact on EDS/CDS ratios. Journal of Political Economy 81(3). ‘Pricing options on scalar diﬀusions: an eigenfunction expansion approach’. 22. Operations research 51(2). The strongest ones are that there is only one factor driving both the credit and the equity process and we neglect information about economic cycles by calibrating to through-the-cycle rating transition probabilities. Zavidonov (2003).uk/ calban. U. Black. (1975). One could wonder whether a two factor model calibrated to point-in-time information would yield instead diﬀerent results. On the other hand. Discrete credit barrier models. and S. J. 637–54. E-mail address: claudio. Stanford University (reprinted in Journal of Portfolio Management.uk Oliver Chen.

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