Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds

descriptionPublicationkeyboard_double_arrow_right Article , Other literature type , Preprint , Report 01 Jan 2013 Germany Publisher:Center for Open ScienceJournal:SSRN Electronic Journal (eissn: 1556-5068,

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Authors: Xiao, Tim;

Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds

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Abstract

This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.

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Germany

Related Organizations

Ludwig-Maximilians-Universität München
Germany
University of Toronto
Canada

Keywords

bepress|Social and Behavioral Sciences|Economics, Arabixiv|Social and Behavioral Sciences, jump diffusion model, hybrid financial instrument, convertible bond, convertible underpricing, convertible arbitrage, default time approach, default probability (intensity) approach, asset pricing, credit risk modeling., jump diffusion, convertible bond, convertible underpricing, convertible arbitrage, default time approach, default probability approach, asset pricing and credit risk modeling., Futures Pricing, Trading Volume, Financial Risk and Risk Management, default time approach, Sociology, default probability approach, G13 - Contingent Pricing, G12 - Asset Pricing, Bond Interest Rates, Goodwill, ddc:330, SocArXiv|Social and Behavioral Sciences|Economics, asset pricing, bepress|Social and Behavioral Sciences|Economics|Finance, jump diffusion, credit risk modeling, convertible arbitrage, FOS: Sociology, G32 - Financing Policy, convertible underpricing, SocArXiv|Social and Behavioral Sciences|Economics|Finance, Arabixiv|Social and Behavioral Sciences|Economics|Finance, bepress|Social and Behavioral Sciences, Value of Firms, SocArXiv|Social and Behavioral Sciences, Arabixiv|Social and Behavioral Sciences|Economics, Capital and Ownership Structure, convertible bond, Finance, jel: jel:G12, jel: jel:G13, jel: jel:G32

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