Modeling CDS Spreads A Comparison of Some Hybrid Approaches

Journal of Empirical Finance 57 (2020) 107–124
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Journal of Empirical Finance

journal homepage: www.elsevier.com/locate/jempfin
Modeling CDS spreads: A comparison of some hybrid approaches

Luca Vincenzo Ballestra a , Graziella Pacelli b ,∗, Davide Radi c,d
a Department of Statistical Sciences, Alma Master Studiorum Universitá di Bologna, Bologna, Italy
b
Department of Management, Universitá Politecnica delle Marche, Ancona, Italy
c
Department of Economics and Management, Universitá di Pisa, Pisa, Italy
d
Department of Finance, V˘SB–Technical University of Ostrava, Ostrava, Czech Republic
ARTICLE INFO ABSTRACT

Keywords: According to the credit risk model proposed by Cathcart and El-Jahel (2006), default can occur
Default risk either expectedly, when a certain signaling variable breaches a lower barrier, or unexpectedly,
Credit default swap as the first jump of a Poisson process, whose intensity depends on the signaling variable itself
CDS
and on the interest rate. In the present paper we test the performances of such a model and of
Hybrid model
other three models generalized by it in fitting the term structure of credit default swap (CDS)
spreads. In order to do so, we derive a semi-analytical formula for pricing CDSs and we use it
to fit the observed term structures of 65 different CDSs. The analysis reveals that all the model
parameters yield a relevant contribution to credit spreads. Moreover, if the dependence of the
default intensity on both the signaling variable and the interest rate is removed, the pricing
of CDSs becomes very simple, from both the analytical and the computational standpoint,
while the goodness-of-fit is reduced by only a few percentage points. Therefore, when using
the credit risk model proposed by Cathcart and El-Jahel (2006), assuming a constant default
intensity provides an interesting and efficient compromise between parsimony and goodness-
of-fit. Furthermore, by fitting the term structure of CDS spreads on a period of about twelve
years, we find that the parameters of the model with constant default are rather stable over
time, and the goodness-of-fit is maintained high.
1. Introduction
Credit risk, or default risk, is the risk of a financial loss when a counterparty to a transaction fails to fulfill its financial obligations
following previously agreed terms. This is a relevant issue that one should take into account when pricing financial products such
as corporate bonds, government bonds and credit derivatives. The risk of default is difficult to quantify as it often depends on latent
factors or variables that are not straightforward to measure. The financial literature offers several models to assess credit risk, which,
generally speaking, can be divided in three main categories: structural, reduced-form and hybrid.
Structural models evaluate the risk of default of a firm issuing a debt based on one or more variables related to its capital
structure. In particular, the first structural model proposed in the literature, which is due to Merton (1974), assumes that a firm
only defaults at debt maturity if at that time the value of its assets is lower than the value of its obligations. The Merton’s model has
subsequently been extended so as to take into account the possible occurrence of premature bankruptcy and debt seniority (Black and
Cox, 1976), stochastic interest rates (Longstaff and Schwartz, 1995; Bernard et al., 2005), tax benefits (Anderson and Sundaresan,
1996), debt restructuring (Abínzano et al., 2009) and downgrade-triggered termination clauses (Feng and Volkmer, 2012).
Structural models often fail to provide an accurate evaluation of the probability of default. In particular, several empirical studies,
see, e.g. Jones et al. (1984) and Franks and Torous (1989), reveal that structural models usually underestimate short-term default
∗ Correspondence to: Piazzale Martelli 8, 60121, Ancona, Italy.

E-mail address: g.pacelli@staff.univpm.it (G. Pacelli).
https://doi.org/10.1016/j.jempfin.2020.03.001
Received 28 March 2019; Received in revised form 30 January 2020; Accepted 30 March 2020
Available online 10 April 2020
0927-5398/© 2020 Elsevier B.V. All rights reserved.
L.V. Ballestra, G. Pacelli and D. Radi Journal of Empirical Finance 57 (2020) 107–124
probabilities, which in turn causes underestimation of credit spreads for short debt maturities.1 This is due to the fact that the value
of the firm’s assets is generally specified as a continuous-time stochastic process. Therefore, a sudden reduction of it, which can
justify default in the short run, occurs with a theoretical probability that is very close to zero, contrary to what happens in reality,
see, e.g., Crouhy et al. (2000) and Bäuerle (2002). To overcome this issue, structural models with unexpected jumps in the value
of the firm’s assets have been proposed by, e.g., Zhou (2001), and have been further developed in order to incorporate stochastic
volatility (Zhang et al., 2009) and macroeconomic risk (Jang et al., 2016). Nevertheless, if on one hand this helps to reduce the
systematic underestimation of credit spreads for short debt maturities, on the other analytical tractability is lost.
Unlike structural models, according to which default is to some extent predictable (a firm goes bankrupt only if it is in financial
distress), reduced-form models assume that default occurs unexpectedly as the first jump of a counting process whose intensity,
termed default intensity or hazard rate, is prescribed exogenously, see, e.g., Jarrow and Turnbull (1995), Lando (1998), Duffee
(1999), Duffie and Singleton (1999), Lando (2004), Madan and Schoutens (2008), Schoutens and Cariboni (2009), Duffie and
Singleton (2003) and Fontana and Montes (2014). These approaches allow one to take into account the possible occurrence of
a sudden (unpredictable) default event and henceforth the high credit spreads that are often experienced for short debt maturities
can be adequately recovered. In addition, reduced-form models are relatively simple from the mathematical standpoint and thus
they usually provide closed-form solutions. However, in spite of their flexibility, they have some disadvantages. Specifically, they
tend to overestimate default probabilities for short debt maturities, see, e.g., Gündüz and Uhrig-Homburg (2014), they are not able
to produce steep enough term structures as pointed out in Duffee (1999), and they do not take into account any information about
the capital structure of firms.
To overcome the issues of structural and reduced-form models, hybrid models have been developed, see, e.g., Madan and Unal
(1998), Duffie and Lando (2001), Cathcart and El-Jahel (2006, 2003), Giesecke (2006) and Ballestra et al. (2017), which combine
the structural and the reduced-form approaches. In this way, structural information is taken into account and, at the same time,
high short-term spreads can be reproduced.
An interesting hybrid model is that proposed in Cathcart and El-Jahel (2006), according to which the default probability is
related to the risk-free interest rate and to a signaling variable measuring credit quality. In particular, the short-term interest rate
is assumed to follow a Cox–Ingersoll–Ross (CIR) process, see Cox et al. (1985), the signaling variable is modeled as a geometric
Brownian motion and the default intensity is specified as a function of the interest rate and of the signaling variable itself. Such
an approach has the advantage of taking into account various market determinants of credit spreads, namely the interest rate,
firm’s credit quality and, most importantly, the idiosyncratic volatility, see, e.g., Collin-Dufresne and Goldstein (2001), Campbell
and Taksler (2003), Avramov et al. (2007), Lekkos (2007), Cremers et al. (2008), Zinna (2013), Galil et al. (2014) and Jang et al.
(2016).
The (Cathcart and El-Jahel, 2006) model (CE model, in short) generalizes two other models, namely, the hybrid one proposed
in Cathcart and El-Jahel (2003) (CEa model, in short), where the hazard rate is a function of the interest rate only, and the structural
one considered in Cathcart and El-Jahel (1998) (CEb model, in short), where default cannot occur unexpectedly and is driven by
the signaling variable breaching the lower barrier only.
The CEb, CEa and CE models have been introduced with the purpose of pricing defaultable bonds. In particular, a defaultable
bond pricing formula is derived by Cathcart and El-Jahel (2006) for the CE model, by Cathcart and El-Jahel (2003) for the CEa
model and, finally, by Cathcart and El-Jahel (1998) for the CEb model. However, these three models have never been applied to
price credit default swaps (CDSs, hereafter). CDSs are the main financial instruments to hedge and trade credit risk and they have
become the market standard for assessing the creditworthiness of a large number of companies, with the CDS market that has grown
substantially in the last two decades.
In the present paper we derive semi-analytical formulas for pricing single-name CDSs under the CE, the CEa and the CEb models.
The CE, CEa and CEb models are in increasing order of analytical tractability (since they are nested one within the other) and the
computational complexity of the formulas we obtain reflects this. Then, since the CE model is much more expensive from the
computational standpoint than the CEa and the CEb models, it is interesting to test whether the parameters of the CE model are
all relevant in predicting CDS term structures, or if we can instead set some of them to zero (thus employing the CEa or the CEb
models) without strongly affecting the quality of the data fitting.
To give an answer to this question, we investigate the capabilities of the aforementioned models to reproduce real CDS term
structures. Specifically, the analysis is performed by leveraging a dataset of 65 CDSs issued by companies with different S&P’s rating.
In addition to the CE, CEa and CEb models, we also consider a specification of the CE model with constant default intensity (HCI
hereafter, where HCI stands for hybrid model with constant intensity), whose analytical tractability is comparable to that of the
CEb model.
The empirical analysis reveals that all the parameters of the CE model yield a relevant contribution to the computation of CDS
spreads and thus when pricing credit default swaps it is important to take into account both expected and unexpected default. In
particular, the four models are highly sensitive to the barrier level, to the volatility of the signaling variable and to the parameters
of the intensity of default. Moreover, as far as the quality of the data fitting is concerned, the CE model provides an excellent
goodness-of-fit, with the mean absolute percentage error for a single CDS term structure that is equal to 2.42% on the average.
However, the goodness-of-fit of the CEa and the HCI models are rather similar to that of the CE model. Specifically, the average
pricing errors achieved by the CEa and the HCI models are equal to 3.44% and 4.25%, respectively. By contrast, the CEb yields a
much lower goodness-of-fit, with an average error that is equal to 23.95%.
1 An empirical study by Li and Wong (2008) shows that the underestimation issue is attenuated if structural models are calibrated by the maximum likelihood
approach developed in Duan (1994), but this estimation procedure is very time consuming, see Li and Wong (2008).
108
Finally, as far as computational time is concerned, the HCI model is, approximately, twenty times faster than the CEa model,
hundreds of times faster than the CE model and as fast as the CEb model. Thus, if we look at both computational costs and goodness-
of-fit, the HCI model turns out to be the best choice, or at least an excellent compromise between efficiency and precision. Therefore,
as a further empirical investigation, we calibrated the HCI model by fitting the term structure of CDS spreads in the period 2007–
2019, using monthly data. The results obtained reveal that if we exclude the period immediately after the 2008 financial crisis, the
parameters of the model are stable over time and the goodness-of-fit is maintained high.
The road map of the paper is the following. Section 2 introduces the CE framework. Section 3 presents the formula for pricing
credit default swaps under the CE model. Section 4 outlines the CDS pricing formula for the CEa, the CEb and the HCI models.
Section 5 shows the empirical analysis assessing the goodness-of-fit of the four models considered and the sensitivity of their
parameters. Section 6 concludes. The derivation of the CDS pricing formulas is provided in Appendix A.
2. The CE model
The hybrid framework (CE model) proposed by Cathcart and El-Jahel (2006) is based on two main factors, namely the short-term
risk-free interest rate and a signaling variable measuring credit quality.
The short-term default-free rate, which we denote with 𝑟, is specified as a CIR stochastic process (under the risk-adjusted
measure), see Cox et al. (1985):
√
𝑑𝑟 (𝑡) = 𝑘 (𝜇 − 𝑟 (𝑡)) 𝑑𝑡 + 𝜎𝑟 𝑟 (𝑡)𝑑𝑊1 (𝑡) (1)
where 𝜇, 𝜎𝑟 and 𝑘 are positive constants and 𝑊1 is a standard Wiener process.

Based on the process (1), the risk-neutral price at some initial time 𝑡0 of a pure discount bond with maturity 𝑇 is given by (see
again Cox et al. (1985)):
[ ]
( ( ) ) 𝑇
− ∫ 𝑟(𝑢)𝑑𝑢
𝑃 𝑟 𝑡0 , 𝑡0 ; 𝑇 = E 𝑒 𝑡0 = 𝑒𝐴(𝑇 −𝑡0 )+𝐵 (𝑇 −𝑡0 )𝑟(𝑡0 ) (2)
where
⎛ (𝑘−𝜑)(𝑇 −𝑡0 ) ⎞
( ) 2𝑘𝜇 ⎜ 2𝜑𝑒 2 ⎟
𝐴 𝑇 − 𝑡0 = ln ⎜ ( )⎟ (3)
𝜎𝑟2 ⎜ 2𝜑 + (𝑘 − 𝜑) 1 − 𝑒 −𝜑 (𝑇 −𝑡 0 ) ⎟
⎝ ⎠
and
( )
( ) −2 1 − 𝑒−𝜑(𝑇 −𝑡0 ) √
𝐵 𝑇 − 𝑡0 = ( ), 𝜑= 𝑘2 + 2𝜎𝑟2 (4)
2𝜑 + (𝑘 − 𝜑) 1 − 𝑒−𝜑(𝑇 −𝑡0 )
According to Cathcart and El-Jahel (2006), let us further consider a signaling variable 𝑥 and let us assume that its risk-adjusted
dynamics follows the diffusion process:
𝑑𝑥 (𝑡) = 𝛼𝑥 (𝑡) 𝑑𝑡 + 𝜎𝑥 𝑥 (𝑡) 𝑑𝑊2 (𝑡) (5)
where 𝛼 and 𝜎𝑥 > 0 are constants, while 𝑊2 is a standard Wiener process uncorrelated with 𝑊1 .
The signaling variable is an indicator of the credit quality of a firm, a high (low) value of it implying a high (low) credit quality.
For example, this variable could be taken to be the value of the corporate total assets.
Moreover, always based on (Cathcart and El-Jahel, 2006), we make the following assumption.
Assumption 1. If 𝑥 hits the lower threshold value 𝑥𝑙 , then the firm defaults. However, default can also occur as the first jump of
a Poisson process whose hazard rate (default intensity) is specified as follows:
𝑥𝑙
𝜆 (𝑥, 𝑟) = 𝑎 + 𝑏𝑟 + 𝑐 (6)
𝑥
where 𝑎, 𝑏 and 𝑐 are constants.
The specification (6) allows us to take into account the eventual dependence of the default intensity on both the signaling variable
and the default-free interest rate. In particular, default becomes more (less) likely the closer (further) the signaling variable is to
(from) the default boundary.
As far as the recovery rate is concerned, according to Cathcart and El-Jahel (2006) (see also Gündüz and Uhrig-Homburg, 2014)
we make the following assumption (so-called recovery of treasury).
Assumption 2. In case of default, which occurs at a (random) time which we denote by 𝑡𝑑 , the bondholder receives 𝛿 default-free
pure discount bonds with same maturity and promised payment as for the original security, where 𝛿 ∈ [0, 1) is constant.
109
3. Pricing CDSs using the CE model
In this section, we derive the price of a credit default swap under the CE model. Let us consider a CDS written on a one-dollar
bond, with initial protection time 𝑡0 and final protection time 𝑇 (then 𝑇 − 𝑡0 is the time to maturity), and let 𝑡𝑑 denote the random
time of default. Moreover, let us denote the CDS spread by 𝛱 and let us assume that it is paid continuously. Then, at time 𝑡0 the
premium leg is given by (see, e.g., Brigo and Mercurio (2007) and Gündüz and Uhrig-Homburg (2014))
[ ]
𝑇 𝑧
− ∫𝑡 𝑟(𝑢)𝑑𝑢
PremiumLeg = E 𝛱 𝑒 0 𝟏{𝑡𝑑 >𝑧} 𝑑𝑧 (7)
∫ 𝑡0
where 𝟏{⋅} denotes the indicator function. Moreover, let 𝐿𝐺𝐷 denote the single protection payment (so-called loss given default),
operated at the time of default 𝑡𝑑 . According to Assumption 2, we have:
( ( ) )
𝐿𝐺𝐷 = (1 − 𝛿) 𝑃 𝑟 𝑡𝑑 , 𝑡𝑑 ; 𝑇 (8)
( ( ) )
where 𝑃 𝑟 𝑡𝑑 , 𝑡𝑑 ; 𝑇 is the price at time 𝑡𝑑 of a default-free discount bond with maturity 𝑇 and it is given by (2). Therefore, the
protection leg is given by
[ ]
𝑡
− ∫ 𝑑 𝑟(𝑢)𝑑𝑢 ( ( ) )
ProtectionLeg = E 𝑒 𝑡0 (1 − 𝛿) 𝑃 𝑟 𝑡𝑑 , 𝑡𝑑 ; 𝑇 𝟏{𝑇 ≥𝑡𝑑 >𝑡0 } (9)
By equating the premium leg to the protection leg and solving for 𝛱, we obtain the so-called CDS par spread (hereafter simply
refereed to as CDS spread) at the initial protection time:
[ ]
𝑡
− ∫ 𝑑 𝑟(𝑢)𝑑𝑢 ( ( ) )
E 𝑒 𝑡0 (1 − 𝛿) 𝑃 𝑟 𝑡𝑑 , 𝑡𝑑 ; 𝑇 𝟏{𝑇 ≥𝑡𝑑 >𝑡0 }
( ( ) ( ) )
𝛱 𝑥 𝑡0 , 𝑟 𝑡0 , 𝑡0 ; 𝑇 = [ ] (10)
𝑇 𝑧
− ∫𝑡 𝑟(𝑢)𝑑𝑢
E 𝑒 0 𝟏{𝑡𝑑 >𝑧} 𝑑𝑧
∫ 𝑡0
A semi-analytical formula for computing the right hand side of (10) is proposed in the following Proposition (see the proof in
Appendix A).
Proposition 1. The CDS spread in (10), which for the sake of clarity we denote by 𝛱𝐶𝐸 , can be computed as follows:
( ( ( ) ) ) ( )
( ( ) ( ) ) 1 − 𝑓 𝑥 𝑡0 , 𝑇 − 𝑡0 𝑒𝐶 (𝑇 −𝑡0 )+𝐷(𝑇 −𝑡0 )𝑟(𝑡0 ) (1 − 𝛿) 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇
𝛱𝐶𝐸 𝑥 𝑡0 , 𝑟 𝑡0 , 𝑡0 ; 𝑇 = (11)
𝑇 −𝑡0 ( ( ) )
𝑓 𝑥 𝑡0 , 𝑠 𝑒𝐸1 (𝑠)+𝐸2 (𝑠)𝑟(𝑡0 ) 𝑑𝑠
∫0
where
( )
𝑓 (𝑥, 𝜏) = −1 𝐹 (𝑥, 𝜏) (12)
[ ]
with 𝜏 ∈ 0, 𝑇 − 𝑡0 , and 𝑓 is a suitable function whose Laplace transform 𝐹 is derived in Cathcart and El-Jahel (2006) and is given by:
{ ( ( 𝑐𝑥 )𝛾 ) ( ) ( ( ) )
𝜁 ( ) 1+𝜉+𝑛 1+𝜉+𝑛 3+𝜉+𝑛 (𝜂𝑐 𝛾 )2
𝐼𝑛 𝜂 𝑥𝑙 𝐼−𝑛 (𝜂𝑐 𝛾 )(𝜂𝑐 𝛾 )1+𝜉+𝑛 𝛤 𝐻 , 1+𝑛, 2 , 4
2−1−𝑛 𝜋𝜂 𝛾 𝑐𝑥𝑙 𝜁 2 2
𝐹 (𝑥, 𝑞) = − ( )
𝜎𝑥2 𝛾 2 sin(𝜋𝑛) 𝑥 𝐼𝑛 (𝜂𝑐 𝛾 )𝛤 (1+𝑛)𝛤
3+𝜉+𝑛
2
( ( 𝑐𝑥 )𝛾 ) ( )( ( 𝑐𝑥 )𝛾 )1+𝜉−𝑛 ( ( ) ( ( 𝑐𝑥 )𝛾 )2 )
1+𝜉−𝑛 1+𝜉−𝑛 3+𝜉−𝑛
22𝑛 𝐼𝑛 𝜂 𝑥𝑙 𝛤 2
𝜂 𝑥𝑙 𝐻 2
, 1−𝑛, 2 , 14 𝜂 𝑥𝑙
− ( )
3+𝜉−𝑛
𝛤 (1−𝑛)𝛤
( ( 𝑐𝑥 )𝛾 ) ( ) ( 2
( ) ) (13)
2𝑛 𝑙 1+𝜉−𝑛 𝛾 1+𝜉−𝑛 1+𝜉−𝑛 3+𝜉−𝑛 (𝜂𝑐 𝛾 )2
2 𝐼𝑛 𝜂 𝑥 𝛤 2
(𝜂𝑐 ) 𝐻 2
, 1−𝑛, 2 , 4
+ ( )
3+𝜉−𝑛
𝛤 (1−𝑛)𝛤
) ( ) ( ( 𝑐𝑥 )𝛾 )2 ) }
2
( ( 𝑐𝑥 )𝛾 )( ( 𝑐𝑥 )𝛾 )1+𝜉+𝑛 ( (
1+𝜉+𝑛 1+𝜉+𝑛 3+𝜉+𝑛
𝐼−𝑛 𝜂 𝑥𝑙 𝜂 𝑥𝑙 𝛤 2
𝐻 2
, 1+𝑛, 2 , 14 𝜂 𝑥𝑙
+ ( )
3+𝜉+𝑛
𝛤 (1+𝑛)𝛤 2
where
√ √
𝛼 1 1 8 2𝑞 𝜁 +𝛾
𝜁= − , 𝛾= , 𝜂= , 𝑛=2 𝜁2 + , 𝜉=− (14)
𝜎𝑥2 2 2 𝜎𝑥 𝜎𝑥2 𝛾
and 𝐼𝑛 (⋅), 𝐻 (⋅, (⋅, ⋅) , ⋅) and 𝛤 (⋅) are the modified Bessel function of the first kind with 𝑛 degrees of freedom, the generalized hypergeometric
( )
function (see, e.g., Slater (1966)) and the Gamma function, respectively. Moreover, 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇 is defined in (2) and
( 2
)
⎛ 𝑎𝜎
𝑘−𝜚− 𝑘𝜇𝑟 2𝑠 ⎞
2𝑘𝜇 ⎜ 2𝜚𝑒 ⎟ −2 (𝑏 + 1) (1 − 𝑒−𝜚𝑠 )
𝐸1 (𝑠) = ln ⎜ −𝜚𝑠 ) ⎟
, 𝐸2 (𝑠) = (15)
𝜎𝑟2 ⎜ 2𝜚 + (𝑘 − 𝜚) (1 − 𝑒 ⎟ 2𝜚 + (𝑘 − 𝜚) (1 − 𝑒−𝜚𝑠 )
⎝ ⎠
110
Furthermore,
√
𝜚 = 𝑘2 + 2 (𝑏 + 1) 𝜎𝑟2 (16)
( ]
and, for 𝑠 ∈ 0, 𝑇 − 𝑡0 , 𝐶 (𝑠) and 𝐷 (𝑠) satisfy the following system of ordinary differential equations:
1 2 ( )
𝜎 𝐷 (𝑠)2 + 𝜎𝑟2 𝑟𝐵 (𝑠) − 𝑘 𝐷 (𝑠) − 𝐷𝑠 (𝑠) − 𝑏 = 0
2 𝑟 (17)
𝑘𝜇𝐷 (𝑠) − 𝐶𝑠 (𝑠) − 𝑎 = 0
subject to the initial conditions 𝐶 (0) = 0 and 𝐷 (0) = 0, where 𝐵 (𝑠) is defined in (4).
To compute the CDS spread in (11) we have to invert the Laplace transform in (13), i.e. we have to compute −1 𝐹 , which
cannot be done analytically. Thus, we use a numerical inversion method, in particular we employ the algorithm of Gaver–Stehfest,
see e.g. Stehfest (1970), Gaver-Jr. (1966) and Kuznetsov (2013). Moreover, to solve the differential equations in (17) and to compute
the integral in (11) we use numerical approximation routines available in MATLAB.
4. Models generalized by the CE model
The Cathcart and El-jahel’s framework is quite general and includes other models as special cases, which are described in the
following:
The CEa model: (Cathcart and El-Jahel, 2003) consider a simpler model where the hazard function in (6) does not depend on
the signaling variable 𝑥. This is obtained by setting 𝑐 = 0 in (6). The following Proposition (see the proof in Appendix A) yields a
semi-analytical formula for computing the spread of a CDS using the CEa model.
Proposition 2. Let us assume 𝑐 = 0. Then, the CDS spread in (10) can be computed as follows:
( )
⎛ ⎛ ( ( )) 1− 2𝛼2 ln
𝑥 𝑡0( )
( ( ))⎞ ⎞ ( )
⎜1 − ⎜𝑁 𝑑1 𝑇 − 𝑡0 − 𝑒 𝜎𝑥 𝑥𝑙
𝑁 𝑑2 𝑇 − 𝑡0 ⎟ 𝑒𝐶 (𝑇 −𝑡0 )+𝐷(𝑇 −𝑡0 )𝑟(𝑡0 ) ⎟ (1 − 𝛿) 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇
⎜ ⎜ ⎟ ⎟
( ( ) ( ) ) ⎝ ⎝ ⎠ ⎠
𝛱𝐶𝐸𝑎 𝑥 𝑡0 , 𝑟 𝑡0 , 𝑡0 ; 𝑇 = ( )
𝑇 −𝑡0 ⎛ ( )
𝑥(𝑡 )
1− 2𝛼2 ln 𝑥 0 ( )⎞
⎜𝑁 𝑑1 (𝑠) − 𝑒 𝜎𝑥 𝑙
𝑁 𝑑2 (𝑠) ⎟ 𝑒𝐸1 (𝑠)+𝐸2 (𝑠)𝑟(𝑡0 ) 𝑑𝑠
∫0 ⎜ ⎟
⎝ ⎠
(18)
where 𝑁 (⋅) is the cumulative distribution function of a standard normal distribution,
( ) ( )
𝑥(𝑡 ) 𝑥(𝑡 )
ln 𝑥 0 + 𝛼 − 12 𝜎𝑥2 𝑠 − ln 𝑥 0 + 𝛼 − 12 𝜎𝑥2 𝑠
𝑙 𝑙
𝑑1 (𝑠) = √ , 𝑑2 (𝑠) = √ (19)
𝜎𝑥 𝑠 𝜎𝑥 𝑠
( )
and 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇 is defined in (2), while 𝐶 (𝑠), 𝐷 (𝑠), 𝐸1 (𝑠) and 𝐸2 (𝑠) are defined as in Proposition 1.
The CEb model: (Cathcart and El-Jahel, 1998) consider a simpler version of the CE model (also of the CEa model) with null
default intensity, which is obtained by setting 𝑎 = 0, 𝑏 = 0 and 𝑐 = 0 in (6). The following Proposition (see the proof in Appendix A)
yields a semi-analytical formula for pricing a CDS using the CEb model.
Proposition 3. Let us assume 𝑎 = 0, 𝑏 = 0 and 𝑐 = 0. Then, the CDS spread in (10) can be computed as follows:
( )
⎛ ( ( ))
𝑥(𝑡 )
1− 2𝛼2 ln 𝑥 0 ( ( ))⎞ ( )
⎜1 − 𝑁 𝑑1 𝑇 − 𝑡0 + 𝑒 𝜎𝑥 𝑙
𝑁 𝑑2 𝑇 − 𝑡0 ⎟ (1 − 𝛿) 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇
⎜ ⎟
( ( ) ( ) ) ⎝ ⎠
𝛱𝐶𝐸𝑏 𝑥 𝑡0 , 𝑟 𝑡0 , 𝑡0 ; 𝑇 = ( ) (20)
𝑇 −𝑡0 ⎛ ( )
𝑥(𝑡 )
1− 2𝛼2 ln 𝑥 0 ( )⎞ ( )
⎜𝑁 𝑑1 (𝑠) − 𝑒 𝜎𝑥 𝑙
𝑁 𝑑2 (𝑠) ⎟ 𝑃 𝑟(𝑡0 ), 𝑇 − 𝑠; 𝑇 𝑑𝑠
∫0 ⎜ ⎟
⎝ ⎠
( 𝑁 (⋅) is) the cumulative distribution function of a standard normal distribution, 𝑑1 (𝑠) and 𝑑2 (𝑠) are defined as in Proposition 2, while
where
𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇 is defined in (2).
The HCI model: This is a simpler version of the CE model with constant (not necessarily null) default intensity in (6), which is
obtained by setting 𝑏 = 0 and 𝑐 = 0 in (6). The following Proposition (see the proof in Appendix A) yields a semi-analytical formula
for pricing a CDS using the HCI model.
Proposition 4. Let us assume 𝑏 = 0 and 𝑐 = 0. Then, the CDS spread in (10) can be computed as follows:
( )
⎛ ⎛ ( ( ))
𝑥(𝑡 )
1− 2𝛼2 ln 𝑥 0 ( ( ))⎞ ⎞ ( )
⎜1 − ⎜𝑁 𝑑1 𝑇 − 𝑡0 − 𝑒 𝜎 𝑥 𝑙
𝑁 𝑑2 𝑇 − 𝑡0 ⎟ 𝑒−𝑎(𝑇 −𝑡0 ) ⎟ (1 − 𝛿) 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇
⎜ ⎜ ⎟ ⎟
( ( ) ( ) ) ⎝ ⎝ ⎠ ⎠
𝛱𝐻𝐶𝐼 𝑥 𝑡0 , 𝑟 𝑡0 , 𝑡0 ; 𝑇 = ( ) (21)
𝑇 −𝑡0 ⎛ ( )
𝑥(𝑡 )
1− 2𝛼2 ln 𝑥 0 ( )⎞ ( )
⎜𝑁 𝑑1 (𝑠) − 𝑒 𝜎 𝑙
𝑥 𝑁 𝑑2 (𝑠) ⎟ 𝑒−𝑎𝑠 𝑃 𝑟(𝑡0 ), 𝑇 − 𝑠; 𝑇 𝑑𝑠
∫0 ⎜ ⎟
⎝ ⎠
111
Fig. 1. Fitting the term structure of U.S. Treasury STRIPS Bonds.
( )
where 𝑑1 (𝑠) and 𝑑2 (𝑠) are defined as in Proposition 2, while 𝑃 𝑟(𝑡0 ), 𝑡0 ; 𝑇 is defined in (2).
5. Empirical analysis
Our goal is to test the ability of the CE model and of all the simpler models described in Section 4 to replicate the term structure
of CDS spreads for CDS contracts written on corporate bonds.
5.1. Data source
We use a dataset of (single-name) credit default swaps. The CDS data are obtained from the Thomson Reuters Eikon database. For
each CDS, Thomson Reuters Eikon provides the CDS spread, the name of the reference company (the S&P’s rating of the company
is available too), the maturity, the currency on which it is quoted, the geographic area of exchange, the restructuring clauses in the
CDS contract (as set out by the International Swaps and Derivatives Association), and the type of debt on which it is written.
We choose a dataset of CDSs written on bonds issued by 65 different companies, paying attention to have at least one company for
each S&P’s rating. Following (Packer and Zhu, 2005) and consistently with Assumption 1, we only include CDSs with restructuring
clause XR14, i.e. no restructuring. Furthermore, we only collect CDSs written on debts classified as senior unsecured and traded in
U.S. dollars. The 65 companies considered are listed in Table 8 in Appendix B.
For each of the 65 CDSs employed, we consider CDS spreads observed at October 1, 2019 (𝑡0 ), with the following times to
maturity: 𝑇1 = 1 year, 𝑇2 = 2 years, 𝑇3 = 3 years, 𝑇4 = 4 years, 𝑇5 = 5 years, 𝑇6 = 7 years, and 𝑇7 = 10 years.
Moreover, we also use a dataset of U.S. Treasury STRIPS Bonds traded in U.S. dollars. In particular, we consider the prices of
310 bonds on October 1 2019, with different maturities ranging from 15 days to 10 years.
5.2. Calibration procedure
To test the ability of the models to replicate the term structure of CDS spreads, we proceed as follow. First of all, we estimate the
CIR model given in Fig. 1 by fitting realized zero-coupon bond prices. ( )This is done
( by applying) a calibration procedure analogous to
the one proposed in Mannolini et al. (2008). Specifically, let 𝑃 ∗ 𝑡0 , 𝑇̂𝑖 and( 𝑃 𝑟0 , 𝑡
)0 ; ̂𝑖 denote the empirical and theoretical prices
𝑇
at time 𝑡0 of the U.S. Treasury
( ) STRIPS Bond with maturity 𝑇̂𝑖 , where 𝑃 𝑟0 , 𝑡0 ; 𝑇̂𝑖 is given in (2), 𝑖 = 1, 2 … , 310, (for the sake of
2
simplicity we set 𝑟0 = 𝑟 𝑡0 ). Then, the parameters 𝑟0 , 𝑘, 𝜇 and 𝜎𝑟 are computed by minimizing the mean absolute percentage error
(MAPE):2
( ) ( )
1 ∑ || 𝑃 𝑡0 , 𝑇̂𝑖 − 𝑃 𝑟0 , 𝑡0 ; 𝑇̂𝑖 ||
310 ∗
( )
MAPE𝐵𝑜𝑛𝑑 𝑟0 , 𝑘, 𝜇, 𝜎𝑟2 = | ( ) | (22)
310 𝑖=1 || 𝑃 ∗ 𝑡0 , 𝑇̂𝑖 |
|
The estimated values of 𝑟0 , 𝑘, 𝜇, 𝜎𝑟2 , are reported in Table 1. As we can observe, the CIR model fits the term structure of the U.S.
Treasury STRIPS Bonds very well since MAPE𝐵𝑜𝑛𝑑 is only 0.12%. Looking at Fig. 1, we may also appreciate the very good agreement
between theoretical and empirical data.
2 The calibration is performed by using the prices of all U.S. Treasury STRIPS Bonds of type principal-only that are made available by Thomson Reuters
Eikon, which have a maturity lower than or equal to ten years, are quoted on the 1st of October 2019 and are traded in U.S. Dollars. In total we collect the
prices of 310 different U.S. Treasury STRIPS Bonds.
112
Table 1
Parameters of the CIR model.
Parameter Value
𝑟0 0.0150335
𝑘 0.0150053
𝜇 0.0343607
𝜎𝑟2 0.0010003
MAPE𝐵𝑜𝑛𝑑 0.12%
Once the interest rate model Fig. 1 is estimated, we calibrate one by one the CE, CEa, CEb and HCI models. To this aim, the
values of the interest rate parameters are set as in Table 1 and the recovery rate 𝛿 is chosen equal to 0.4, which is a very typical
value in the literature, see e.g. Altman and Kishore (1996), Jankowitsch et al. (2008) and Madan (2014). Then, the remaining
model parameters are obtained by fitting the term structure of realized CDS spreads. This is done by using a calibration procedure
analogous to the one proposed in Hao et al. (2013) and Ballestra et al. (2017), which, for the sake of brevity, is illustrated here
𝑥
by considering the CE model only. Specifically, the parameters of the CE model that still need to be computed, namely 𝑥0 , 𝛼, 𝜎𝑥2 ,
𝑙
𝑎, 𝑏 and 𝑐, are obtained by minimizing the mean absolute percentage error (MAPE) between the empirical CDS spreads and the
theoretical ones:
( ) ( ) ( )
1 ∑ || 𝛱 𝑡0 , 𝑇𝑖 − 𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 ||
7 ∗
𝑥0
MAPE𝐶𝐷𝑆 , 𝛼, 𝜎𝑥2 , 𝑎, 𝑏, 𝑐 = | ( ) | (23)
𝑥𝑙 7 𝑖=1 || 𝛱 ∗ 𝑡0 , 𝑇𝑖 |
|
( ) ( )
where 𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 is evaluated using the CDS pricing formula (11), while 𝛱 ∗ 𝑡0 , 𝑇𝑖 denotes the observed value (at time 𝑡0 )
of the spread of a CDS with maturity 𝑇𝑖 . An analogous procedure is adopted to calibrate the CEa, CEb and HCI models.
From the theoretical standpoint, we decided to use the MAPE error measure (23) due to various reasons. First of all, a relative
error measure allows us to avoid to overweight the bias in fitting long-term CDS spreads (which are usually the highest ones) and
underweight the bias in fitting short-term CDS spreads (which are usually the lowest ones). Moreover, since we want to test the
performance of the models in replicating the term structure of CDS spreads, we avoid to employ the root mean square percentage
error (RMSPE). In fact, in principle, the RMSPE would give more weight to a large error concentrated at a single maturity than to
small errors distributed over different maturities of the term structure. Nevertheless, from the practical standpoint, we also performed
the calibrations using the RMSPE and the results obtained (not reported in order to save space) are substantially analogous to those
experienced using the MAPE.
5.3. Empirical findings and sensitivity analysis
The calibrated values of the parameters of the four models considered are reported in Tables 9–12 in Appendix B. In these tables
the results are summarized by dividing the 65 companies in three groups according to their S&P’s rating. In particular, the first
group includes companies with credit rating form AAA to A, the second group includes companies with credit rating from A- to
BBB, the third group includes companies with credit rating lower than BBB.
𝑥
Concerning the CE model, see Table 9, the results show that the value of 𝑥0 , which measures the distance from the default
𝑙
barrier, is about 2.85 for the group of companies with the highest credit rating, decreases to about 2.55 for the group of companies
with intermediate credit rating and is about 2.40 for the group of companies with the lowest credit rating. These results agree with
the fact that a higher credit rating is associated to a lower probability of default, and thus to a higher value of the distance to the
default barrier. Moreover, we observe that the average value of the drift parameter 𝛼 is positive for the group of firms with high
and intermediate rating, while it is negative for the group of companies with low rating. This is consistent with the fact that a low
rating is associated with a negative financial outlook, which is reflected by a negative value of the drift parameter. Furthermore,
we observe that the first two groups of companies, i.e. the ones with the highest credit rating, are characterized by a volatility
parameter which is about 20% on the average, with a maximum at about 30% and a minimum at about 12%. On the contrary,
the group of companies with the lowest credit ratings is characterized by an average volatility of about 23%, with peaks of about
60%, indicating that the lowest ratings are associated with the highest uncertainty on the creditworthiness. As far as the intensity of
default is concerned, on the average it is 0.2% for both the first and the second group of companies, and raises up to 3% for the group
of firms with low credit rating. This is consistent with fact that companies with low credit rating have usually a higher probability
to default unexpectedly. The same results are obtained for the CEa model (Table 10) and for the HCI model (Table 11), and similar
results are also obtained for the CEb model (Table 12), where the magnitude of some structural parameters is slightly different in
order to compensate the fact that the intensity of default is equal to zero (thus the structural component has more weight).
Let us now investigate the sensitivity of the computed CDS spreads with respect to each parameter of the four models considered.
Specifically, we consider the variation of the CDS spreads due to 10% variations of the model parameters. For example, let us focus
our attention on the CE model( and, for the sake ) of simplicity,(in order to )stress out the dependence of the CDS spreads on the model
parameters, let us write 𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 , 𝜃 instead of 𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 , where 𝜃 denotes any of the parameters of the CE model.
Then, the elasticity with respect to the parameter 𝜃 is measured as follows:
( ) ( )
1 ∑ 𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 , 𝜃 + 5% |𝜃| − 𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 , 𝜃 − 5% |𝜃|
7
𝐸𝜃 = ( ) (24)
7 𝑖=1 10%𝛱𝐶𝐸 𝑥0 , 𝑟0 , 𝑡0 ; 𝑇𝑖 , 𝜃
113
Table 2
Sensitivity analysis for the CE model. The elasticity with respect to each parameter is computed according to formula
(24).
𝐸 𝑥0 𝐸𝛼 𝐸𝜎𝑥 𝐸𝑎 𝐸𝑏 𝐸𝑐
𝑥𝑙
Average −0.841 −0.181 2.279 6.375 7.486 3.564

Min −10.088 −0.761 0.240 0.037 0.000 0.000
Max 12.682 0.789 4.645 25.859 30.375 14.425
Standard deviation 5.124 0.312 0.892 6.487 7.138 3.722
Table 3
Sensitivity analysis for the CEa model.
𝐸 𝑥0 𝐸𝛼 𝐸𝜎𝑥 𝐸𝑎 𝐸𝑏
𝑥𝑙
Average −2.873 −0.388 2.372 2.795 2.844

Min −4.456 −0.712 0.616 0.037 0.000
Max −1.142 −0.129 4.645 13.999 14.067
Standard deviation 0.889 0.186 1.035 3.901 3.988
Table 4
Sensitivity analysis for the HCI model.
𝐸 𝑥0 𝐸𝛼 𝐸𝜎𝑥 𝐸𝑎
𝑥𝑙
Average −3.063 −0.440 3.189 0.446

Min −4.641 −1.132 0.614 0.157
Max −1.130 −0.111 5.280 0.810
Standard deviation 0.794 0.230 0.979 0.125
Table 5
Sensitivity analysis for the CEb model.
𝐸 𝑥0 𝐸𝛼 𝐸 𝜎𝑥
𝑥𝑙
Average −10.034 −0.869 7.746

Min −64.171 −2.006 1.188
Max −2.068 −0.027 11.429
Standard deviation 7.491 0.454 2.438
Relation (24) is computed by setting 𝜃 and the remaining model parameters equal to the values that we obtained by calibrating
the model to the 65 term structures. The elasticity 𝐸𝜃 is calculated for each parameter 𝜃 for each of the four models considered,
and the results are summarized in Tables 2–5.
As far as the CE model is concerned (Table 2), we observe that the CDS spread is very sensitive to variations of the structural
𝑥 𝑥
parameters 𝜎𝑥 and 𝑥0 . In fact, on the average, the elasticity with respect to the barrier distance 𝑥0 is in magnitude almost equal to
𝑙 𝑙
one (−0.841), and the elasticity with respect to the volatility parameter 𝜎𝑥 is far larger than one (2.279). By contrast the elasticity
with respect to the drift parameter 𝛼, albeit relevant, is in magnitude smaller (−0.181). Furthermore, the model is also very sensitive
to changes in the reduced-form parameters specifying the intensity of default. Specifically, on the average, the elasticity of the model
with respect to parameters 𝑎, 𝑏 and 𝑐 is far larger than one. Therefore, in summary, CDS spreads are sensitive to both the structural
and the reduced-form components of the model.
The sensitivity analysis of the parameters conducted for the other models confirms these results. In particular, analogous results
are observed for the CEa model, see Table 3. The analysis of the HCI model, see Table 4, indicates a high sensitivity to the barrier
𝑥
distance 𝑥0 and to the volatility of the signaling variable 𝜎𝑥 , while the sensitivity to the intensity of default parameter 𝑎 and to the
𝑙
drift parameter 𝛼 is smaller, but it remains relevant (𝐸𝛼 = −0.440 and 𝐸𝑎 = 0.446). The same kind of results are obtained for the
CEb model, see Table 5.
In order to study the goodness-of-fit of the CE, CEa, HCI and CEb models, let us consider the 65 companies all together. Then, by
examining the MAPE𝐶𝐷𝑆 reported in Table 6, we can see that the CE model fits the term structures of the spreads of the considered
CDSs very well. In fact, MAPE𝐶𝐷𝑆 has an average equal to 2.42%, a maximum equal to 7.01%, a minimum equal to 0.08% and a
standard deviation equal to 1.60%. The CEa model does also perform very well, yielding a MAPE𝐶𝐷𝑆 whose average (3.44%) is only
a percentage point higher than that experienced for the CE model. The performances of the HCI model are similar. Specifically, the
average MAPE𝐶𝐷𝑆 for the HCI model (4.25%) is less than a percentage point higher than the average MAPE𝐶𝐷𝑆 for the CEa model,
and is two percentage points higher than the average MAPE𝐶𝐷𝑆 for the CE model. Moreover, the maximum of the MAPE𝐶𝐷𝑆 for
the HCI model (8.48%) remains substantially the same as that for the CEa model and is less than two percentage points higher than
the MAPE𝐶𝐷𝑆 obtained for the CE model. On the contrary, the CEb model shows very large values of MAPE𝐶𝐷𝑆 , which is equal to
23.95% on the average.
114
Table 6
Average, minimum, maximum values and Standard deviation of MAPE𝐶𝐷𝑆 over the 65 CDS term structures
considered.
MAPE𝐶𝐷𝑆 CE CEa HCI CEb
Average 2.42% 3.44% 4.25% 23.95%
Min 0.08% 0.08% 0.62% 4.20%
Max 7.01% 8.20% 8.48% 34.94%
Standard deviation 1.60% 1.63% 1.70% 5.64%
Table 7
CPU time for obtaining a single CDS spread.
CE CEa HCI CEb
CPU time 0.520 s 0.022 s 9.403 × 10−4 s 8.750 × 10−4 s
To better evaluate the goodness-of-fit of the four models considered, in Fig. 2 we report the term structures of six CDSs issued
by companies with different S&P’s rating (ranging from AAA to B-). As we may observe, the CE, CEa and HCI models fit the six
empirical term structures very well. By contrast, the CEb model fails to cope with the slightly increasing term structures of Microsoft
Corp, of Nike Inc, of Oracle Corporation and of Con Edison Company of NY Inc (see Fig. 2(a)–(d)) and with the high short-term
credit spreads of the term structures of Ford Motor Credit Company LLC and McClatchy Company (see Fig. 2(e) and (f)). In summary,
all the models, except for the CEb one, are capable to replicate, with different levels of accuracy, all the possible shapes of the CDS
term structures that are experienced in the market.
As already mentioned, the four models considered have different levels of analytical complexity and thus their computational
times are different. In Table 7, we report the computer time required by each model in order to evaluate a single CDS spread (we
used a computer Intel Core i7 CPU, 2.3 GHz, and we wrote all the software codes in Matlab 9.3). As we may observe, both the CEb
and the HCI models take approximately the same amount of time, and they are more than twenty times faster than the CEa model
and more than five hundred times faster than the CE model.
Putting all things together, we conclude that the HCI model ensures the best trade-off between goodness-of-fit and computational
cost. In fact, the HCI model is less accurate than the CE model of few percentage points only (see Table 6), but it is also more than
five hundred times faster (see Table 7).
5.4. Further evidences on the HCI model
As already observed, the HCI model offers the best good trade-off between computational simplicity and goodness-of-fit.
Therefore, to better illustrate the performances of this model, we calibrated it over a time horizon of about 12 years, from December
2007 to September 2019, in order to test the stability of the estimated parameters and to check if the goodness-of-fit is maintained.
Specifically, on the first trading day of each month from December 2007 to September 2019, we calibrate the CIR process (1)
by fitting the prices of U.S. Treasury STRIPS Bonds (using the same procedure employed in Section 5.2). Then, we estimate the
remaining parameters of the HCI model by fitting the term structure of CDS spreads (we consider CDSs with the same maturities
as in Section 5.2 on the first trading day of every month form December 2007 to September 2019). We conduct this analysis for
seven companies, one for each class of S&P’s rating.
In Fig. 3, we report the results obtained for Johnson & Johnson, whose S&P’s rating is AAA. As we may notice, the MAPE𝐶𝐷𝑆 is
𝑥
confined in the range 2% − 20%. The volatility parameter 𝜎𝑥 and the barrier distance 𝑥0 remain almost constant over the entire time
𝑙
interval from December 2007 to September 2019. On the contrary, the drift parameter 𝛼 and the hazard rate 𝑎 show some large
fluctuations in the period 2008–2010, but this is due to large increases in the levels of CDS spreads. Specifically, the hazard rate
grows substantially in the time interval immediately after 2008, due to the financial crisis, and thus the reduced-form component
of the risk of default is particularly high.
Similar results are observed for the other six companies considered, see Figs. 4, 5, 6, 7, 8, 9. Finally, in all the cases, the MAPE𝐶𝐷𝑆
is in line with the values reported in Table 6. That is the HCI model yields a very satisfactory goodness-of-fit also if CDS spreads
spanning almost twelve years are considered.
6. Conclusions
In this paper, the credit risk model proposed by Cathcart and El-Jahel (2006) and other three models generalized by
it are tested and compared on the pricing of CDSs. Specifically, semi-analytical formulas are derived which yield the CDS
spread under the four models and are used to fit the realized term structures of the spreads of CDSs issued by 65 different
companies.
The calibrated values of the parameters are used to conduct a sensitivity analysis, which underlines that the models considered
are particularly sensitive to structural parameters such as the distance to the default barrier and the volatility parameter as well as
115
Fig. 2. Theoretical (CE model in red, CEa model in blue, HCI model in green and CEb in magenta) and empirical (in black) term structures of CDSs written on
bonds issued by: Microsoft Corp, Standard and Poor’s rating AAA (panel a), Nike Inc, Standard and Poor’s rating AA- (panel b), Oracle Corporation, Standard
and Poor’s rating A+ (panel c), Con Edison Company of NY Inc, Standard and Poor’s rating A- (panel d), Ford Motor Credit Company LLC, Standard and Poor’s
rating BBB (panel e) and McClatchy Company, Standard and Poor’s rating B- (panel f).
116
Fig. 3. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for Johnson &
𝑥
Johnson (AAA). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
Fig. 4. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for 3M Company
𝑥
(AA-). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
to reduced-form parameters specifying the intensity of default. Moreover, the empirical analysis reveals that the CE model fits the
market data very well, yielding a mean absolute percentage error that, on the average, is equal to 2.42% only. At the same time, if
we assume that the default intensity depends on the interest rate only, as in the CEa model, or that the default intensity is constant,
as in the HCI model, the mean absolute percentage error increases, on the average, but the difference with respect to the CE model
is only of few percentage points. On the contrary, if the default intensity is set equal to zero, as in the CEb model, the goodness-of-fit
is considerably spoiled, with the mean absolute percentage error that is, on the average, greater than 20%.
As far as the computational performance is concerned, the HCI and CEb models take less than a millisecond to evaluate a single
CDS spread, while the CEa and CE models are twenty times and five hundred times slower, respectively. As the CDS spread needs to
be computed thousands of times in order to calibrate each model, the lower computational times of the HCI and CEb models offer
a key advantage to practitioners.
Looking at both goodness-of-fit and computational time, we conclude that the HCI model provides an excellent compromise
between goodness-of-fit and computation burden. Finally, a further empirical analysis conducted during the period from December
2007 to September 2019 shows that, if we exclude the two years immediately after the 2008 financial crisis, the parameters of the
HCI model are stable over time and the pricing error is maintained small.
117
Fig. 5. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for Occidental
𝑥
Petroleum Corp (A). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
Fig. 6. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for Citigroup
𝑥
Inc (BBB+). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
Fig. 7. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for Goodyear
𝑥
Tire and Rubber Company (BB). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
118
Fig. 8. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for Dole Food
𝑥
Company Inc (B-). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
Fig. 9. Historical calibration of the CDS spread curves (based on CDSs with 1-year, 2-year, 3-year, 4-year, 5-year, 7-year and 10-year maturities) for Neiman
𝑥
Marcus Group LTD LLC (CCC). Panel (a), MAPE𝐶𝐷𝑆 . Panel (b), 𝑥0 . Panel (c), 𝛼. Panel (d), 𝜎𝑥 . Panel (e), 𝑎. Panel (f), CDS spread with 5-year maturity.
𝑙
Declaration of competing interest
The authors declare that they have no known competing financial interests or personal relationships that could have appeared
to influence the work reported in this paper.
CRediT authorship contribution statement
Luca Vincenzo Ballestra: Formal analysis, Investigation, Methodology. Graziella Pacelli: Formal analysis, Writing - review &
editing, Data curation. Davide Radi: Formal analysis, Investigation, Methodology.
Acknowledgments
Davide Radi acknowledges the support of the Czech Science Foundation (GACR) under project [20-25660Y] and VSB-TU Ostrava
Czech Republic under the SGS project SP2020/11.
119
Appendix A. Compute the CDS spread using the CE model
Proof of Proposition 1. Let 𝑡𝑥𝑑 > 𝑡 be the first time 𝑥 hits the lower barrier 𝑥𝑙 , let 𝑡+ denote the minimum between 𝑡𝑥𝑑 and 𝑇 and
let 𝛷 (𝑥 (𝑡) , 𝑟 (𝑡) , 𝑡; 𝑇 ) denote the value of the protection leg in (9) at a generic time 𝑡. Then (see, e.g., Brigo and Mercurio (2007))
[ ]
( ( ) ( )) ( ( ) ) 𝑡+
𝛷 (𝑥 (𝑡) , 𝑟 (𝑡) , 𝑡; 𝑇 ) = E (1 − 𝛿) 𝜆 𝑟 𝑡+ , 𝑥 𝑡+ 𝑃 𝑟 𝑡+ , 𝑡+ ; 𝑇 𝑒− ∫𝑡 (𝜆(𝑟(𝑢),𝑥(𝑢))+𝑟(𝑢))𝑑𝑢
[ + ] (25)
𝑡 𝑧
+ E ∫𝑡 (1 − 𝛿) 𝜆 (𝑟 (𝑧) , 𝑥 (𝑧)) 𝑃 (𝑟 (𝑧) , 𝑧; 𝑇 ) 𝑒− ∫𝑡 (𝜆(𝑟(𝑢),𝑥(𝑢))+𝑟(𝑢))𝑑𝑢 𝑑𝑧
where 𝜆 is as in (6). By Theorem 2.1 in Freidlin (1985, p. 127), 𝛷 (𝑥, 𝑟, 𝑡; 𝑇 ) (for the sake of notational simplicity we drop the
dependence of 𝑥 and 𝑟 on 𝑡 and of 𝛷 on 𝑥, 𝑟 and 𝑡 hereafter) must satisfy the following partial differential equation
𝜎𝑥2 𝜎2
𝛷𝑡 + 𝛼𝑥𝛷𝑥 + 𝑥2 𝛷𝑥𝑥 + 𝑘 (𝜇 − 𝑟) 𝛷𝑟 + 𝑟 𝑟𝛷𝑟𝑟 = (𝜆 + 𝑟) 𝛷 − 𝜆 (1 − 𝛿) 𝑃 (26)
2 2
subject to the following conditions
𝛷 (𝑥, 𝑟, 𝑇 ; 𝑇 ) = 0
( )
𝛷 𝑥 = 𝑥𝑙 , 𝑟, 𝑡; 𝑇 = (1 − 𝛿) 𝑃 (𝑟, 𝑡; 𝑇 )
lim 𝛷 (𝑥, 𝑟, 𝑡; 𝑇 ) = 0 (27)
𝑟→+∞
𝛷𝑟 (𝑥, 𝑟, 𝑡; 𝑇 ) finite as 𝑟 → 0
To solve problem (26)–(27), let us guess a solution of the form
𝛷 (𝑥, 𝑟, 𝑡; 𝑇 ) = (1 − 𝑔 (𝑟, 𝑡; 𝑇 ) 𝑓 (𝑥, 𝑇 − 𝑡)) (1 − 𝛿) 𝑃 (𝑟, 𝑡; 𝑇 ) (28)
where 𝑃 (𝑟, 𝑡; 𝑇 ) is defined in (2). Hence, using the separation of variables, we have that functions 𝑔 and 𝑓 satisfy the partial
differential equations (A12) and (A16), respectively, in Cathcart and El-Jahel (2006), with boundary and initial conditions as
specified there. Then, proceeding as in Cathcart and El-Jahel (2006), we obtain
𝑔 (𝑟, 𝑡; 𝑇 ) = 𝑒𝐶(𝜏)+𝐷(𝜏)𝑟 (29)
where for the sake of simplicity we have set 𝜏 = 𝑇 − 𝑡 and 𝐶 and 𝐷 satisfy the system of ordinary differential equations in (17) with
initial conditions 𝐶 (0) = 0, 𝐷 (0) = 0. Moreover, as indicated in Cathcart and El-Jahel (2006) a closed-form expression for 𝑓 does
not exist, but we can obtain its Laplace transform, which is defined as follows
∞
𝐹 (𝑥, 𝑞) = (𝐹 ) (𝑥, 𝑞) = 𝑒−𝑞𝑠 𝑓 (𝑥, 𝑠) 𝑑𝑠 (30)
∫0
where 𝑞 is the Laplace parameter. Proceeding as in Cathcart and El-Jahel (2006), we obtain 𝐹 as in (13). Then, the expression of
the protection leg follows.
Moreover, let 𝛹 denote the premium leg in (7), divided by 𝛱, which can be rewritten as follows:
[ 𝑇 ]
𝑧
𝛹 (𝑥, 𝑟, 𝑡; 𝑇 ) = E 𝟏{𝑧<𝑡+ } 𝑒− ∫𝑡 (𝜆(𝑟(𝑢),𝑥(𝑢))+𝑟(𝑢))𝑑𝑢
𝑑𝑧 (31)
∫𝑡
Then, by Theorem 2.1 in Freidlin (1985, p. 127), function 𝛹 must satisfy the following partial differential problem:
𝜎𝑥2 𝜎𝑟2
− 𝛹𝑡 − 𝛼𝑥𝛹𝑥 − 𝑥2 𝛹𝑥𝑥 − 𝑘 (𝜇 − 𝑟) 𝛹𝑟 − 𝑟𝛹𝑟𝑟 = 1 − (𝜆 + 𝑟) 𝛹 (32)
2 2
( )
with final condition 𝛹 (𝑥, 𝑟, 𝑇 ; 𝑇 ) = 0 and boundary condition 𝛹 𝑥 = 𝑥𝑙 , 𝑟, 𝑡, 𝑇 = 0. According to Duhamel’ principle, see, e.g., Fritz
(1982), the solution 𝛹 is given by
𝑇 −𝑡
𝛹 (𝑥, 𝑟, 𝑡; 𝑇 ) = 𝑈 (𝑥, 𝑟, 𝑇 − 𝑡; 𝜌) 𝑑𝜌 (33)
∫0
where 𝑈 (⋅, ⋅, ⋅; 𝜌) satisfies the following partial differential equation:
𝜎𝑥2 𝜎2 ( 𝑐𝑥 )
𝑈𝑡 + 𝛼𝑥𝑈𝑥 + 𝑥2 𝑈𝑥𝑥 + 𝑘 (𝜇 − 𝑟) 𝑈𝑟 + 𝑟 𝑟𝑈𝑟𝑟 = (𝜆 + 𝑟) 𝑎 + (𝑏 + 1) 𝑟 + 𝑙 𝑈 (34)
2 2 𝑥
𝑈 (𝑥, 𝑟, 𝜌; 𝜌) = 1
( ) (35)
𝑈 𝑥 = 𝑥𝑙 , 𝑟, 𝑇 − 𝑡; 𝜌 = 0
120
Since (34) is a homogeneous partial differential equation, we can guess its solution in the following form:
𝑈 (𝑥, 𝑟, 𝑇 − 𝑡; 𝜌) = ℎ (𝑟, 𝑇 − 𝑡; 𝜌) 𝑓 (𝑥, 𝑇 − 𝑡 − 𝜌) (36)
and, using separation of variables, we have that 𝑓 is the same function as in (28), whose Laplace transform is given by (13), whereas
ℎ satisfies the partial differential problem:
𝜎𝑟2
ℎ𝑡 + 𝑘 (𝜇 − 𝑟) ℎ𝑟 + 𝑟ℎ𝑟𝑟 = (𝑎 + (𝑏 + 1) 𝑟) ℎ (37)
2
ℎ (𝑟, 𝜌; 𝜌) = 1
lim ℎ (𝑟, 𝑇 − 𝑡; 𝜌) = 0 (38)
𝑟→+∞
ℎ𝑟 (𝑟, 𝑇 − 𝑡; 𝜌) finite as 𝑟 → 0
To solve the partial differential problem (37)–(38), let us guess a solution of the following form
̄ ̄
ℎ (𝑟, 𝑇 − 𝑡; 𝜌) = 𝑒𝐸1 (𝜏;𝜌)+𝐸2 (𝜏;𝜌)𝑟 (39)
where 𝜏 = 𝑇 − 𝑡 and 𝐸̄ 1 (𝜌; 𝜌) = 𝐸̄ 2 (𝜌; 𝜌) = 0. Then, substituting (39) into (37) yields the following system of two ordinary differential
equations:
𝜎𝑟2 2
𝐸̄ 2,𝜏 = 𝐸̄
2 2
− 𝑘𝐸̄ 2 − (𝑏 + 1)
(40)
𝐸̄ 1,𝜏 = 𝑘𝜇 𝐸̄ 2 − 𝑎
The first of (40) is a standard Riccati’s equation, whose solution can be easily obtained (see Polyanin and Zaitsev (2003, p. 106 and
p. 237)):
( )
−2 (𝑏 + 1) 1 − 𝑒−𝜚(𝜏−𝜌)
𝐸̄ 2 (𝜏; 𝜌) = ( ) (41)
2𝜚 + (𝑘 − 𝜚) 1 − 𝑒−𝜚(𝜏−𝜌)
where 𝜚2 = 𝑘2 + 2 (𝑏 + 1) 𝜎𝑟2 . Then, since 𝐸̄ 1,𝜏 = 𝑘𝜇𝐸̄ 2 − 𝑎 and 𝐸̄ 1 (𝜌; 𝜌) = 0, by standard integration we obtain
( 2
)
⎛ 𝑎𝜎
𝑘−𝜚− 𝑘𝜇𝑟
−𝜚(𝜏−𝜌)
⎞
̄ 2𝑘𝜇 ⎜ 2𝜚𝑒 2
⎟
ln ⎜ ( ) (42)
−𝜚(𝜏−𝜌) ⎟
𝐸1 (𝜏; 𝜌) =
𝜎𝑟2 ⎜ 2𝜚 + (𝑘 − 𝜚) 1 − 𝑒 ⎟
⎝ ⎠
Since 𝐸̄ 1 and 𝐸̄ 2 depend on the difference between 𝜏 and 𝜌 only, we can more compactly write 𝐸̄ 1 (𝜏; 𝜌) = 𝐸1 (𝑠) and 𝐸̄ 2 (𝜏; 𝜌) = 𝐸2 (𝑠),
where 𝐸1 (⋅) and 𝐸2 (⋅) are as in (15), and 𝑠 = 𝜏 − 𝜌. Hence, the premium leg evaluated at time 𝑡0 is
( ( ) ( ) ) 𝑇 −𝑡0 ( ( ) )
𝛹 𝑥 𝑡0 , 𝑟 𝑡0 , 𝑡0 ; 𝑇 = 𝑓 𝑥 𝑡0 , 𝑠 𝑒𝐸1 (𝑠)+𝐸2 (𝑠)𝑟(𝑡0 ) 𝑑𝑠 (43)
∫0
Thus, formula (11) follows. ■
Proof of Propositions 2–4. The proof of Proposition 2 is analogous to that of Proposition 1, with the only exception that, since
𝑐 = 0, the partial differential problem (A16) in Cathcart and El-Jahel (2006) reduces to a homogeneous partial differential problem
whose solution is straightforward, see, e.g. Cathcart and El-Jahel (2003). Then, proceeding as in the proof of Proposition 1, formula
(18) follows.
The proof of Proposition 3 is analogous to that of Proposition 1, with few exceptions. Since 𝑐 = 0, the partial differential problem
(A16) in Cathcart and El-Jahel (2006) reduces to a homogeneous partial differential problem whose solution is straightforward, see,
e.g. Cathcart and El-Jahel (2003). Since 𝑎 = 0 and 𝑏 = 0, we have 𝑔 (𝑟, 𝑇 − 𝑡) = 1 in (28) and ℎ (𝑟, 𝑇 − 𝑡; 𝜌) = 1 in (36).
The proof of Proposition 4 is analogous to that of Proposition 1, with few exceptions. Since 𝑐 = 0, the partial differential problem
(A16) in Cathcart and El-Jahel (2006) reduces to a homogeneous partial differential problem whose solution is straightforward, see,
e.g. Cathcart and El-Jahel (2003). Since 𝑏 = 0, we have that 𝑔 (𝑟, 𝑇 − 𝑡) = 𝑒𝐶(𝑇 −𝑡)+𝐷(𝑇 −𝑡)𝑟 in (28) does not depend on 𝑟, i.e. 𝐷 (𝑇 − 𝑡) = 0,
𝐶 (𝑇 − 𝑡) = −𝑎, and ℎ (𝑟, 𝑇 − 𝑡; 𝜌) = 𝑒−𝑎(𝑇 −𝑡−𝜌) in (36). ■
121
Appendix B. Empirical results
See Tables 8–12.
Table 8
List of the 65 companies to which the CDS spreads used for the calibration refer to and their S&P’s credit rating.
Company S&P’s rating Company S&P’s rating
Johnson & Johnson AAA Goldman Sachs Group Inc BBB+
Microsoft Corp AAA Nordstrom Inc BBB+
Apple Inc AA+ AT&T Inc BBB+
Exxon Mobil Corp AA+ Lockheed Martin Corp BBB+
Chevron Corp AA+ Norfolk Southern Corp BBB+
3M Company AA− Capital One Bank USA NA BBB+
Toyota Motor Credit Corp AA− Dow Chemical Company BBB
Nike Inc AA− Hewlett-Packard BBB
Citibank NA A+ Rohm and Haas Company BBB
Bank of America NA A+ FedEx Corp BBB
Boeing Capital Corp A+ Ford Motor Credit Company LLC BBB
Boeing Company A+ Ingersoll-Rand Inc BBB
IBM Corp A+ Capital One Financial Corp BBB
Oracle Corp A+ Arconic Inc BBB−
Georgia-Pacific LLC A+ Hess Corp BBB−
U.S. Bancorp A+ Arrow Electronics Inc BBB−
Caterpillar Financial Services Corp A Unum Group BB+
Caterpillar Inc A Gap Inc BB+
Deere & Company A Goodyear Tire and Rubber Company BB
John Deere Capital Corp & Co A MGM Resorts International BB−
The Hershey Company A Safeway Inc B+
Occidental Petroleum Corp A New Albertson’s Inc B+
Raytheon Company A Sprint Capital Corp B
Union Pacific Corp A Sprint Communications Inc B
Aon Corp A− Advanced Micro Devices Inc B−
Con Edison Company of NY Inc A− Beazer Homes USA Inc B−
JPMorgan Chase & Co A− Chesapeake Energy Corp B−
United Technologies Corp A− Dole Food Company Inc B−
Citigroup Inc BBB+ DISH DBS Corp B−
Morgan Stanley BBB+ McClatchy Company B−
Key Corp Limited BBB+ Unisys Corp B−
Bank of America Corp BBB+ Neiman Marcus Group LTD LLC CCC
Countrywide CR Industries Inc BBB+
Table 9
Parameter estimation for the CE model. The 65 companies considered (see Table 8) are aggregated in three groups according to their S&P’s rating. The first
group includes companies with credit rating form AAA to A, the second group includes companies with credit rating from A−to BBB, the third group includes
companies with credit rating lower than BBB.
𝑥0 𝑥
𝑥𝑙
𝛼 𝜎𝑥 𝑎 𝑏 𝑐 𝜆 = 𝑎 + 𝑏𝑟0 + 𝑐 𝑥 𝑙
0
Average 2.847 0.049 0.210 −0.024 2.611 −0.032 0.002

Min 1.995 0.007 0.118 −0.094 0.128 −0.119 0.000
(AAA) – (A)
Max 4.682 0.109 0.297 0.019 5.000 0.080 0.005
Standard deviation 0.606 0.026 0.034 0.027 1.485 0.055 0.001
Average 2.550 0.032 0.198 −0.038 2.806 −0.003 0.002
Min 2.138 −0.034 0.150 −0.125 −0.239 −0.116 0.000
(A−) – (BBB)
Max 3.627 0.197 0.285 0.034 8.476 0.123 0.007
Average 2.402 −0.044 0.230 0.011 0.916 0.017 0.030
Min 1.553 −0.514 0.154 −0.126 −3.873 −0.129 0.002
(BBB−) – (CCC)
Max 3.916 0.188 0.599 0.238 4.999 0.147 0.205
122
Table 10
Parameter estimation for the CEa model. The 65 companies considered (see Table 8) are aggregated in three groups according to their S&P’s rating. The first
group includes companies with credit rating form AAA to A, the second group includes companies with credit rating from A− to BBB, the third group includes
companies with credit rating lower than BBB.
𝑥0
𝑥𝑙
𝛼 𝜎𝑥 𝑎 𝑏 𝜆 = 𝑎 + 𝑏𝑟0
Average 2.787 0.044 0.211 −0.034 2.402 0.002

Min 1.976 0.005 0.138 −0.117 0.128 0.000
(AAA) – (A)
Max 4.354 0.098 0.259 0.001 7.850 0.004
Average 2.508 0.026 0.197 −0.034 2.451 0.003
Min 2.179 −0.034 0.151 −0.125 0.025 0.000
(A−) – (BBB)
Max 3.558 0.175 0.276 0.002 8.476 0.007
Average 2.378 −0.044 0.230 0.010 1.483 0.033
Min 1.570 −0.514 0.154 −0.194 −3.873 0.002
(BBB−) – (CCC)
Max 3.631 0.197 0.599 0.235 13.118 0.246
Table 11
Parameter estimation for the HCI model. The 65 companies considered (see Table 8) are aggregated in three groups
according to their S&P’s rating. The first group includes companies with credit rating form AAA to A, the second group
includes companies with credit rating from A−to BBB, the third group includes companies with credit rating lower than
BBB.
𝑥0
𝑥𝑙
𝛼 𝜎𝑥 𝑎
Average 2.691 0.046 0.214 0.002

Min 1.933 0.012 0.145 0.001
(AAA) – (A)
Max 3.476 0.084 0.270 0.005
Average 2.465 0.027 0.199 0.003
Min 2.078 −0.035 0.148 0.001
(A−) – (BBB)
Max 3.353 0.155 0.278 0.007
Average 2.350 −0.042 0.230 0.033
Min 1.570 −0.514 0.155 0.002
(BBB−) – (CCC)
Max 3.316 0.197 0.599 0.246
Table 12
Parameter estimation for the CEb model. The 65 companies considered (see Table 8) are aggregated in three groups
according to their S&P’s rating. The first group includes companies with credit rating form AAA to A, the second group
includes companies with credit rating from A−to BBB, the third group includes companies with credit rating lower than
BBB.
𝑥0
𝑥𝑙
𝛼 𝜎𝑥
Average 2.356 0.065 0.218

Min 1.749 0.027 0.154
(AAA) – (A)
Max 2.867 0.136 0.274
Average 2.204 0.044 0.205
Min 1.756 −0.028 0.150
(A−) – (BBB)
Max 2.921 0.179 0.287
Average 2.234 −0.057 0.247
Min 1.791 −0.641 0.171
(BBB−) – (CCC)
Max 2.898 0.046 0.648
123
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Modeling CDS Spreads A Comparison of Some Hybrid Approaches

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Journal of Empirical Finance 57 (2020) 107–124

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Journal of Empirical Finance

Modeling CDS spreads: A comparison of some hybrid approaches

ARTICLE INFO ABSTRACT

∗ Correspondence to: Piazzale Martelli 8, 60121, Ancona, Italy.

where 𝜇, 𝜎𝑟 and 𝑘 are positive constants and 𝑊1 is a standard Wiener process.

𝑑𝑥 (𝑡) = 𝛼𝑥 (𝑡) 𝑑𝑡 + 𝜎𝑥 𝑥 (𝑡) 𝑑𝑊2 (𝑡) (5)

3. Pricing CDSs using the CE model

4. Models generalized by the CE model

Fig. 1. Fitting the term structure of U.S. Treasury STRIPS Bonds.

5.1. Data source

5.2. Calibration procedure

5.3. Empirical findings and sensitivity analysis

Average −0.841 −0.181 2.279 6.375 7.486 3.564

Average −2.873 −0.388 2.372 2.795 2.844

Average −3.063 −0.440 3.189 0.446

Average −10.034 −0.869 7.746

5.4. Further evidences on the HCI model

Declaration of competing interest

CRediT authorship contribution statement

Appendix A. Compute the CDS spread using the CE model

𝛷 (𝑥, 𝑟, 𝑡; 𝑇 ) = (1 − 𝑔 (𝑟, 𝑡; 𝑇 ) 𝑓 (𝑥, 𝑇 − 𝑡)) (1 − 𝛿) 𝑃 (𝑟, 𝑡; 𝑇 ) (28)

𝑔 (𝑟, 𝑡; 𝑇 ) = 𝑒𝐶(𝜏)+𝐷(𝜏)𝑟 (29)

𝑈 (𝑥, 𝑟, 𝑇 − 𝑡; 𝜌) = ℎ (𝑟, 𝑇 − 𝑡; 𝜌) 𝑓 (𝑥, 𝑇 − 𝑡 − 𝜌) (36)

Thus, formula (11) follows. ■

Appendix B. Empirical results

See Tables 8–12.

Average 2.847 0.049 0.210 −0.024 2.611 −0.032 0.002

Average 2.787 0.044 0.211 −0.034 2.402 0.002

Average 2.691 0.046 0.214 0.002

Average 2.356 0.065 0.218

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