A Structural Credit-Risk Model

based on a Jump Diusion

Matthias Scherer
Department of Financial Mathematics
University of Ulm
Working Paper Preprint: This draft: December 2, 2005
First draft: July 1, 2005
Abstract
In this paper, we generalize the pure diusion approach for structural credit
risk modeling by including jumps in the rm-value process. In pure diusion
models, the probability for a solvent company to default within a small inter-
val of time is negligible, whereas a real company may face sudden nancial
distress. Our generalization allows those unpredicted extremal events, rais-
ing the probability for a solvent company to default within a small interval
of time to a realistic level. Compared to a pure diusion model, includ-
ing jump risk increases credit spreads especially for small maturities. The
resulting term structure of credit spreads is extremely exible, hence, our
model provides a powerful tool to t a real spread curve.
Evaluating bond prices in a jump-diusion model is complicated, as the dis-
tribution of rst-passage times is not available in closed form. We present two
approaches to overcoming this problem. First, we derive a semi-analytical
Monte Carlo simulation which is unbiased and ecient and allows all possible
jump distributions. The algorithm only requires us to simulate the rm value
at the times of jumps and not on a ne grid. Then, we analytically calculate
bond prices conditioned on the simulated jumps. The second approach to
rst-passage times and bond pricing uses specic properties of jumps with
two-sided exponential distribution. In this scenario it is possible to calculate
the Laplace transform of survival probabilities. Those survival probabilities
are then recovered numerically and used to price corporate bonds.
The last section of this paper presents a method of obtaining parameter es-
timates based on observed bond prices. Our rst results indicate that the
overall volatility of the rm-value process is explained to a large extent by
jumps, supporting the need for unpredicted jump risk in a realistic rm-value
model.
1
2
1 Introduction
1.1 Structural default models
0.0 0.2 0.4 0.6 0.8 1.0
Time
8
5
9
0
9
5
1
0
0
1
0
5
1
1
0
Default Threshold
Asset Values
Default
In a structural credit-risk model default
occurs when a company cannot meet its
nancial obligations, or in other words,
when the rm value falls below a certain
threshold. The companys total liabili-
ties are often used as default threshold;
other interpretations are weighted aver-
ages of short- and long-term liabilities
(KMV) or a minimum rm value which
is required to operate the company (Black and Cox 1976). Based on this model,
default probabilities needed to compute bond prices are derived.
1.2 Pure diusion models
0 2 4 6
Time to Maturity
0
.
0
0
0
.
0
5
0
.
1
0
0
.
1
5
C
r
e
d
it

S
p
r
e
a
d
0 2 4 6 8 10
Time to Maturity
0
.
0
0
0
0
.
0
0
2
0
.
0
0
4
0
.
0
0
6
0
.
0
0
8
0
.
0
1
0
0
.
0
1
2
C
r
e
d
it

S
p
r
e
a
d
Industrial BBB +
Industrial BBB -
14.09.2005
In a pure diusion model the rm-value
process is assumed to follow a geomet-
ric Brownian motion. Another issue is
the amount of information available to
an investor who is not involved with
the company. From a mathematical
point of view, it is convenient to assume
the value process of the company to be
perfectly observable. In this scenario,
the distribution of rst-passage times
is well known, which allows closed-form
expressions of zero-coupon bond prices
depending essentially on the parameters
of the diusion. This simplicity turns
out to be at the same time an advantage
and a major weakness of pure diusion
models. If we compare the upper g-
ure, showing a typical term structure of
credit spreads in a pure diusion model,
to an observed term structure of real credit spreads in the lower gure, we no-
tice that the pure diusion model systematically underestimates credit spreads for
1.3 Improving a pure diusion model 3
bonds with small maturities. The reason behind this discrepancy is that even for
small maturities, investors demand compensation for investing in corporate bonds
and not in risk-free alternatives, whereas in a pure diusion model the limit of
credit spreads as maturity tends to zero is zero. Both the hump size structure
and the vanishing limit of credit spreads at zero maturity are inherent features of
pure diusion models. The empirical credit spreads are as observed for BBB+ and
BBB- rated companies in Europe. Data is obtained from Bloomberg at September
14, 2005.
1.3 Improving a pure diusion model
Dierent approaches have been taken to overcome the shortfalls of pure diusion
modes. We introduce and briey summarize them in the following categories.
1.3.1 Including jumps
The rm value of a company may be subject to sudden major changes, due to
external shocks or other unpredicted events. Such an incident cannot be captured
by a pure diusion model, as all trajectories of a geometric Brownian motion are
continuous. Therefore, it is reasonable to leave the class of continuous processes
and use a discontinuous Levy process as model for the value of the rm. Allowing
jumps makes it possible for companies to default within any interval of time, and
the resulting default time is no longer predictable. Levy processes can be obtained
by subordinating a pure diusion model or by directly modeling the rm value as
a Levy process. In both approaches, the distribution of rst-passage times is no
longer analytically obtainable, which complicates the derivation of bond prices. A
reference for a jump-diusion model is Zhou 2001; Cariboni and Schoutens 2004
present a variance-gamma approach.
1.3.2 Working with a reduced or blurred ltration
Another approach is to consider the question of what investors actually observe and
how this can be modeled. Companies have the obligation to publish their balance
sheet every quarter. For outsiders, it is dicult to obtain reliable information
about the rm value in between those dates. Hence, a reasonable model assumption
resulting in a reduction of information is to allow observations of the value process
only at preassigned dates. A second information-based approach is to blur the value
process by adding noise which can be interpreted as accounting inaccuracy. The
pioneering publication in this eld is Due and Lando 1997, who allow investors
4
to observe a disturbed version of the value process at dierent times. The resulting
default intensity is positive and so is the limit of credit spreads for small maturities.
In Giesecke 2001, the default threshold is assumed to be an unobservable random
variable. Here, the default intensity is positive as long as the value process is around
its running minima. C etin, Jarrow, Protter and Yildirim 2004 model default based
on the companys cash-ow process and allow investors to observe the signum of
this process.
2 Model description
We model the value of a company as a stochastic process V = {V
t
}
t0
on the
ltered probability space (, F, F, IP) , where
V
t
= v
0
exp(X
t
), v
0
> 0.
We denote by F = {F
t
}
t0
the natural ltration of the process V , augmented so
to satisfy the usual conditions of completeness and right continuity, i.e. F
t
= (V
s
:
0 s t) = (X
s
: 0 s t). The process X = {X
t
}
t0
is a jump-diusion
process given by
X
t
= t + W
t
+
Nt

i=1
Y
i
.
The sequence of jump sizes {Y
i
}
i1
is i.i.d. with two-sided exponential density
f(x) = p

x
1
{x>0}
+ (1 p)

x
1
{x<0}
. (1)
0.0 0.2 0.4 0.6 0.8 1.0
Time
9
4
9
6
9
8
1
0
0
1
0
2
1
0
4
1
0
6
V
(
t
)
Figure 1: A realization of V
Jump sizes, N
t
and W
t
are mutually
independent. Figure 1 presents a real-
ization of the process V with param-
eters = .02 , = .05 , p = .5 ,
= 3 ,

= 30 and v
0
= 100 .
This jump-diusion process was intro-
duced in the nancial literature by Kou
2002, who used it as a model for stock
prices. We assume the company to de-
fault when its value process falls below
its debt level d . In this case, the holder
of a bond receives some recovery payment. As recovery scheme, we use fractional
recovery of face value at the time of default. Hence, our model consists of the
following parameters:
= The linear trend of the diusion component.
2.1 Basic properties of X and V 5
= The volatility of the diusion component.
= The jump intensity.
p = The probability for a jump to be positive.

= The parameters for positive resp. negative jumps.

v
0
= The initial value of the company.
d = The debt level.
R = The recovery rate.
r = The risk-free interest rate.
2.1 Basic properties of X and V
The following section provides a summary of all properties of X and V which
are later used in our credit-risk model. Most results are obtained from elementary
computations, so proofs are omitted or shortened.
2.1.1 The Levy triple of X
The Levy density of the jump-diusion process X is given by (dx) = f(x)dx.
The n-th absolute moment of X
t
exists for some t > 0 or, equivalently for all
t 0 , if and only if
_
|x|1
|x|
n
(dx) < . This is guaranteed for all n N by
the exponential tails of the jump distribution. We let

c
= +
_
p

1 p

_
(2)
be the center of the process X , and obtain
IE[X
t
] = t
c
, and Var(X
t
) = t
_

2
+
_
p

+
1 p

__
. (3)
The moment-generating function satises IE
_
e
Xt

= e
G()t
, where
G(x) = x +
1
2
x
2

2
+
_
p

x
+
(1 p)

+ x
1
_
. (4)
The Levy-Khinchin representation of the characteristic function is given by
IE
_
e
izXt

= e
t(z)
z R,
with characteristic exponent
(z) =
1
2
z
2

2
+ iz +
_
p

iz
+
(1 p)

+ iz
1
_
. (5)
6
In order to complete the Levy triple of X , we rst notice that
_
|x|1
|x|(dx) < .
This is convenient as we do not have to truncate large jumps, see Cont and Tankov
2004 p. 83. We therefore consider the center of the process X instead of a Levy
drift that depends on the choice of truncation function. This center
c
is linked
to the Levy drift that corresponds to the often-used truncation function 1
{|x|1}
via

c
= +
_
|x|1
x(dx) = +
_
pe

_
1 +
1

_
(1 p)e

_
1 +
1

__
.
Hence, we obtain
= +
_
p
_
1

_
+ (p 1)
_
1

__
Let us summarize the observations made above in the following lemma.
Lemma 2.1 (Levy triple of X )
The Levy triple of X is given by (
c
,
2
, (dx)) , where the centered drift of Equa-
tion (2) is calculated without truncation function and the Levy density is given by
f(x)dx.
2.1.2 Moments of V
The n-th moment of V exists if and only if the corresponding exponential moment
of X is nite. IE[e
nXt
] is nite for some t or, equivalently for all t 0 , if and
only if
_
|x|>1
e
nx
(dx) < . In our scenario, this is fullled as long as

>
n, degenerated cases as p = 0 or = 0 excluded. The moment-generating
function of Equation (4) and the characteristic exponent of Equation (5) provide
two convenient methods for calculating these moments. We obtain
IE[V
t
] = v
0
exp
_
t +
1
2

2
t + t
_
p

1
+
(1 p)

+ 1
1
__
,
Var(V
t
) = v
2
0
_
e
tG(2)
e
2tG(1)
_
.
3 First-passage times
In structural credit-risk models the problem of calculating the probability for the
rm-value process not to fall below the default threshold arises naturally. We dene
the rst-passage time = inf{t 0 : V
t
d} and observe that
IP( > t) = IP
_
inf
0st
V
s
> d
_
= IP
_
inf
0st
X
s
> log (d/v
0
)
_
. (6)
3.1 The pure diusion model 7
We denote the term x = log (d/v
0
) as distance to default for X . Let us remark
that this expression is not well-dened in the nancial literature: sometimes a
normalized distance is also referred to as distance to default. Due to Equation (6)
we can work with the process X instead of the process V . Therefore, we dene
the running inmum and supremum of X as
X
t
= inf
0st
X
s
and X

t
= sup
0st
X
s
.
We also dene the stopping times

b
= inf{t 0 : X
t
b, b < 0} and
b
= inf{t 0 : X
t
b, b > 0}.
3.1 The pure diusion model
The process V simplies to V
t
= v
0
exp(t + W
t
) in a pure diusion model,
which corresponds to = 0 in a jump-diusion model. The pure diusion model
is not only contained in our model, the main reason for studying its properties is
the idea to reduce the jump diusion to a pure diusion model by conditioning on
the number and size of possible jumps. Let us therefore collect some results.
Lemma 3.1 (The minimum of a Brownian motion)
The running minimum of a Brownian motion with drift is inverse Gaussian dis-
tributed, and so are rst-passage times in a pure diusion model. More precisely,
the probability for a Brownian motion with drift starting at x to remain above the
threshold b over an interval of length t is given by

BM
b
(x, t) = IP
x
_
min
0st
W
s
+ s > b
_
= 1
{x>b}
_

_
x b + t

t
_
e
2(xb)
2

_
(x b) + t

t
__
,
where IP
x
denotes the measure under which W
0
= x. Hence, with x = log (d/v
0
) ,
IP( > t) =
_
x + t

t
_
e
2x
2

_
x + t

t
_
. (7)
A proof of this lemma is given in Musiela and Rutkowski 2004 on page 581. Later,
we will also need the probability for a Brownian bridge not to fall below a certain
threshold. This result can be found in Borodin and Salminen 1996 on page 63 for
the maximum of a Brownian bridge or in Karatzas and Shreve 1997 on page 265.
Let us state it for the readers convenience.
3.2 Monte Carlo simulation of rst-passage times 8
Lemma 3.2 (The minimum of a Brownian bridge)
The probability for a Brownian bridge pinned at x and y spanning over an interval
of length t not to fall below the threshold b is given by

BB
b
(x, y, t) = IP
x
_
min
0st
W
s
+ s > b

W
t
+ t = y
_
= 1
{x>b,y>b}
_
1 exp
_

2(y b)(x b)
t
2
__
, (8)
where IP
x
denotes the measure under which W
0
= x.
3.2 Monte Carlo simulation of rst-passage times
Finding the distribution of in a jump-diusion setting is a delicate issue. In
general, closed-form solutions are not known for commonly used jump distributions.
A probabilistic approach to estimating survival probabilities is to perform a Monte
Carlo simulation. The algorithm of our choice is a variant of an algorithm for
pricing barrier options; a description in this context can be found in Cont and
Tankov 2004 on page 177 or in Metwally and Atiya 2002. The idea of our algorithm
is as follows. To eciently estimate passage probabilities of X it is sucient
to simulate the times of the jumps 0 <
1
< . . . <
N
T
< T and the process
X , respectively its left limit, at those times. In a second step, we calculate the
probabilities for Brownian bridges that connect those jumps not to fall below the
passage level. More precise, we rewrite the survival probability of the process X
conditioned on the number of jumps. This gives
IP(
b
> T) = IE
_
1
{XT
>b}

k=0
IP(X
T
> b|N
T
= k)IP(N
T
= k).
Knowing the number of jumps allows us to rewrite IP(X
T
> b|N
T
= k) by
conditioning on the location of the jumps, the size of the jumps and the increments
of the pure diusion in between two jumps. Conditioned on the number of jumps
the jump times are distributed as order statistics. Jump sizes are assumed to
be i.i.d. with density f , and the increments of the pure diusion are Gaussian
distributed with mean t
j
and variance
2
t
j
. This yields for k 1
_
(t
1
,...,t
k
)
[0,T]
k
_
(x
1
,...,x
k
)
(,)
k
_
(y
1
,...,y
k
)
(,)
k
1
{0<t
1
<...<t
k
<T}
k!
T
k
k

j=1

BB
b
(X
t
j1
, X
t
j

, t
j
)

BM
b
(X
t
k
, T t
k
)
t
j
,
2
t
j
(y
j
)f(x
j
)d(y
1
, . . . , y
k
)d(x
1
, . . . , x
k
)d(t
1
, . . . , t
k
),
3.2 Monte Carlo simulation of rst-passage times 9
where t
0
= 0 and we use the abbreviations t
j
= t
j
t
j1
, X
t
j
=

j
i=1
(x
i
+ y
i
)
and X
t
j

j1
i=1
(x
i
+y
i
) +y
j
. The density of a normal distribution is denoted by

,
2 . This articial reformulation of the survival probability not only motivates
the following simulation, it also shows that the algorithm is unbiased.
Algorithm 3.1 (Monte Carlo simulation of rst-passage times)
Repeat the following steps K times and calculate the average over the resulting
conditioned survival probabilities {SP
n
}
n=1,...,K
. We then obtain the estimate
IP(
b
> T)
1
K
K

n=1
SP
n
.
1. Simulate the pure jump part (a)-(c) and the diusion component (d) of X :
(a) The number of jumps N
T
Poi(T) .
(b) The jump times 0 <
1
< . . . <
N
T
< T , uniformly distributed over
the interval [0, T] .
(c) The jump sizes at
i
, distributed with density f from Equation (1) or,
for a dierent model with the respective distribution.
(d) Let
0
= 0 and
N
T
+1
= T . Simulate the increments of the diusion
part X

i1
N(
i
,
2

i
) .
2. Calculate each conditioned survival probability SP
n
:
(a) Let F

be given by
F

= {0 <
1
< . . . <
N
T
< T; X
0
, . . . , X

, X

i
, . . . , X
T
} .
(b) Check whether X

b or X

i
b for some i {0, 1, . . . , N
T
+ 1} .
If so, let SP
n
= 0 and skip (c).
(c) If no passage is observed at any
i
, calculate the probability of each
Brownian bridge connecting X

i1
with X

not to fall below the level

b . This yields
SP
n
= IP(X
T
> b|F

)
=
N
T
+1

i=1
_
1 exp
_

2(X

i1
b)(X

i
b)

i
__
=
N
T
+1

i=1

BB
b
(X

i1
, X

,
i
).
3.3 The Laplace transform of rst-passage times 10
If we compare Algorithm 3.1 to a Monte Carlo simulation that is based on simula-
tions of complete trajectories of X on a discrete grid, we observe two advantages.
First of all, our algorithm is much faster. In each iteration run, X has to be sim-
ulated only at a few points and not on a ne grid. Moreover, even on the smallest
grid one would overestimate the survival probability IP(
b
> T) , as there is always
a small probability for X to fall below b between two points of the grid where X
lies above b . This results in a systematic bias, whereas our algorithm is unbiased.
In the next chapter, we introduce a second non-probabilistic approach to challenge
the problem of nding the distribution of
b
. Those approaches are compared in
Table 6.1 for dierent choices of parameters.
3.3 The Laplace transform of rst-passage times
Due to the memoryless property of the exponential distribution it is possible to
calculate the Laplace transform of IP(
b
t) explicitly. Later, we numerically
recover IP(
b
t) from this transform. Using integration by parts, we obtain
() =
_

0
e
t
IP(
b
t)dt =
1

_

0
e
t
dIP(
b
t) =
1

IE[e

b
]. (9)
Theorem 3.1 presents an analytical expression of the expectation in Equation (9).
To derive this result, we begin with the following lemma, which involves the func-
tion G(x) of Equation (4).
Lemma 3.3 (Roots of G(x) )
Kou and Wang 2003 establish that for > 0 , the function G(x) has exactly
four roots. We denote them by
1,
,
2,
,
3,
and
4,
. Moreover, all roots
are real and satisfy
0 <
1,
<

<
2,
< and 0 <
3,
<

<
4,
< .
Later, we need an ecient method of calculating those roots with high precision
and speed. We therefore propose to solve the equivalent polynomial equation
p(x) = ax
4
+ bx
3
+ cx
2
+ dx + e = 0,
with coecients a =
1
2

2
, b =
1
2

2
(

) , c = (

) +
1
2

+
+ , d = p(

) + (

+ )

( + ) and e =

instead.
Kou and Wang 2003 obtained the expectation
IE
_
e

b
_
= A
1
e
b
1,
+ B
1
e
b
2,
,
3.3 The Laplace transform of rst-passage times 11
where
A
1
=

1,

2,

2,

1,
, B
1
=

2,

1,

2,

1,
.
We alter their proof to obtain the Laplace transforms of IP(
b
t) . This yields
Theorem 3.1 (The Laplace transform of IP(
b
t) )
Fix > 0 and b < 0 . Then
IE[e

b
] = A
2
e
b
3,
+ B
2
e
b
4,
, (10)
where
A
2
=

3,

4,

4,

3,
and B
2
=

4,

3,

4,

3,
.
Also the Laplace transform of IP(
b
t) is easily obtained from Equation (9).
Sketch of the proof: The proof works similarly to the one presented by Kou and
Wang 2003 for the running maximum. We write for short
i
=
i,
and dene the
function
u(x) =
_
1 x b,
A
2
e

3
(bx)
+ B
2
e

4
(bx)
x > b.
After some lengthy algebraic manipulations, we nd
u(x) +L(u)(x) = 0 x > b,
where the innitesimal generator L of the jump diusion X is given by
L(u)(x) =
1
2

2
u

(x) + u

(x) +
_

(u(x + y) u(x)) f(y)dy

with jump density f from Equation (1). We approximate u using a sequence
{u
n
}
nN
of C
2
functions with properties u
n
= u on x b , u
n
= 1 on x b1/n
and u
n
2 . This gives for all x > b
L(u
n
)(x) = u(x) +
_
bx
bx1/n
u
n
(x + y)f(y)dy
_
bx
bx1/n
u(x + y)f(y)dy,
which we use to establish
| u
n
(x) +Lu
n
(x)|

n
x > b.
An application of Itos formula for jump processes gives
e
(t
b
)
u
n
(X
t
b
) = u
n
(X
0
) +
_
t
b
0
e
s
(u
n
(X
s
) +Lu
n
(X
s
)) ds,
3.3 The Laplace transform of rst-passage times 12
from which it follows that
M
n
t
= e
(t
b
)
u
n
(X
t
b
)
_
t
b
0
e
s
(u
n
(X
s
) +Lu
n
(X
s
)) ds
is a local martingale starting at u
n
(0) = u(0) . By dominated convergence, M
n
is
even a martingale. Hence,
IE[M
n
t
] = IE
_
e
(t
b
)
u
n
(X
t
b
)
_
t
b
0
e
s
(u
n
(X
s
) +Lu
n
(X
s
)) ds
_
= u(0).
By uniform convergence, we observe that the second summand vanishes as n tends
to innity. This gives
u(0) = IE
_
e
(t
b
)
u(X
t
b
)

= IE
_
e
(t
b
)
u(X
t
b
)1
{
b
<}

+ IE
_
e
(t
b
)
u(X
t
b
)1
{
b
=}

.
Finally, we let t tend to innity and use that u is bounded and u(X

b
) = 1 on
the set {
b
< } . We conclude
u(0) = IE
_
e

b
u(X

b
)

= IE
_
e

.
3.3.1 Gaver-Stehfest algorithm for Laplace inversion
Now that we found an explicit expression of the Laplace transform of IP(
b
t) ,
we need an algorithm that recovers this probability from the transform. The Gaver-
Stehfest Algorithm has the advantage over most Laplace inversion algorithms that
it purely works on the real line, which is convenient when implementing it. Ad-
vantages and disadvantages of this algorithm, and the following lemmata on which
this method is based, are described in Abate and Whitt 1991.
Lemma 3.4 (Gaver 1966)
For a bounded and real-valued function f , continuous at t , we have
f(t) = lim
n
log 2
t
(2n)!
n!(n 1)!
n

k=0
(1)
k
_
n
k
_

_
(n + k) log 2
t
_
,
where denotes the Laplace transform of f . In what follows, we denote the
sequence of functions inside the limit by

f
n
.
Lemma 3.5 (Stehfest 1970)
A better sequence of weights was found by Stehfest. He showed that with

f
n
, dened
as before in Lemma 3.5, we can approximate f using
f

n
(t) =
n

k=1
w(k, n)

f
k
(t), where w(k, n) =
(1)
nk
k
n
k!(n k)!
.
13
He also presents the asymptotic result
f

n
(t) f(t) = o(n
k
) for all k.
Algorithm 3.2 (Laplace transformation of passage times)
We approximate IP(
b
t) by
IP(
b
t) f

n
(t) =
n

k=1
w(k, n)

f
k+B
(t), B = 2,
where B 0 is the burning-out number as discussed by Kou and Wang 2003.
This approximation converges very quickly: we found that n = 9 is accurate
enough for our problem. Nevertheless, the algorithm is sensitive to the precision
of which the roots of G(x) are calculated. Therefore, we propose to apply
Lemma 3.3 for more numerical stability, as nding the roots of a polynomial can
be done eciently and with high precision. We obtained a good performance using
the Pegasus Algorithm, which is described in Engeln-M ullges and Reuter 1991 on
page 34. Table 6.1 at the end of this text compares Algorithm 3.2 with the Monte
Carlo simulation of Algorithm 3.1 for a selection of dierent parameters.
4 Bond pricing
4.1 Coupon bonds
Pricing a corporate bond with face value F and promised coupon payments q
j
at
0 < t
1
< . . . < t
n
= T reduces to the problem of pricing several zero-coupon bonds,
as we can replicate each coupon bond using a linear combination of zero-coupon
bonds. More precisely, we have
B(t
1
< . . . < t
n
, q) =
n1

j=1
q
j
(0, t
j
) + (F + q
n
)(0, t
n
), (11)
where (0, t
j
) denotes a zero-coupon bond with face value one and maturity t
j
.
Therefore, we can restrict our focus on the analysis of zero-coupon bonds, even if
the vast majority of corporate bonds promise coupon payments periodically.
4.2 Zero-coupon bonds
We now consider the problem of pricing zero-coupon bonds within our framework.
We assume that the holder of a zero-coupon bond receives one Euro if the company
4.2 Zero-coupon bonds 14
survives up to maturity T . Otherwise, the investor receives as recovery payment
a fraction R [0, 1) of his outstanding face value at the time of default. This
yields for the price of a zero coupon with maturity T
(0, T) = IE
_
1
{>T}
e
rT
+ R1
{T}
e
r

, (12)
where r is the risk-free interest rate and the time of default. This recovery
scheme is often called fractional recovery of face value at default.
4.2.1 Pricing in a pure diusion model
In a pure diusion model, it is possible to explicitly evaluate Equation (12). To
begin with, we rewrite the pricing formula as follows:
(0, T) = e
rT
IP( > T) + R
_
T
0
e
rt
dIP( t).
The distribution of was derived in Equation (7), and is now used to evaluate
the expression above. We recall that with x = log (d/v
0
)
IP( > T) =
_
x + T

T
_
e
2x
2

_
x + T

T
_
,
IP( t) =
_
x t

t
_
+ e
2x
2

_
x + t

t
_
.
To evaluate the integral, we make use of a result which is presented in Bielecki and
Rutkowski 2002 on page 74.
Lemma 4.1
For real numbers a , b and c , satisfying b < 0 and c
2
> a , we have
_
y
0
e
ax
d
_
b cx

x
_
=
d + c
2d
g(y) +
d c
2d
h(y),
where we use the abbreviations
d =

c
2
2a, g(y) = e
b(cd)

_
b dy

y
_
and h(y) = e
b(c+d)

_
b + dy

y
_
.
Finally, a lengthy but straightforward calculation shows
(0, T) = e
rT
_

_
b + T

T
_
e
2b
2

_
b + T

T
__
+
R
_
e
b
2
( )

_
b T

T
_
+ e
b
2
( )

_
b + T

T
__
= e
rT

BM
b
(0, T) + Re
b( )
2
_
1
BM
b,
(0, T)
_
. (13)
4.2 Zero-coupon bonds 15
where =
_

2
+ 2r
2
and b = log(d/v
0
) . The notation in
BM
b,
denotes a changed drift in the computation of the respective survival probability
in Lemma 3.2.
4.2.2 Zero-coupon bond pricing via Monte Carlo simulation
The idea of our Monte Carlo simulation to eciently estimate (0, T) in a jump-
diusion model is described in Metwally and Atiya 2002 in the context of pric-
ing barrier options. We use most of their notations and adapt their algorithm
to our problem of pricing a zero-coupon bond. The outline of the algorithm is
as follows. We only simulate the times of the jumps 0 <
1
< . . . <
N
T
<
T and the jump diusion X , respectively its left limits, at those times, i.e.
{X
0
, . . . , X

, X

i
, . . . , X
T
} . Here, we use that X

i1
N(
i
,
2

i
)
and X

i
X

is distributed with density f from Equation (1). We again let F

be given by
F

= {0 <
1
< . . . <
N
T
< T; X
0
, . . . , X

, X

i
, . . . , X
T
} .
The probability for a Brownian bridge anchored at X

i1
and X

not to fall
below the default level b is denoted by
BB
b
(i) =
BB
b
(X

i1
, X

,
i
) ; an ex-
plicit formula is presented in Equation (8). Metwally and Atiya 2002 calculate
the density of the rst-passage time conditioned on the endpoints of a Brownian
bridge. They show that with C
t
, dened to be the event that the process passes
the barrier b for the rst time in the interval [t, t + dt] , we have
g
i
(t) = IP(C
t
dt|X

i1
, X

)
=
X

i1
b
2y
2
(t
i1
)
3/2
(
i
t)
1/2

exp
_

(X

b (
i
t))
2
2(
i
t)
2

(X

i1
b + (t
i1
))
2
2(t
i1
)
2
_
,
where
y =
1

2
2

i
exp
_

(X

i1
X

i
)
2
2
2

i
_
.
We let I be the index of the rst jump such that X

I
crosses the barrier, i.e.
I = min
_
i N : X

j
> b, j = 1, . . . , i; X

j
> b, j = 1, . . . , i 1; X

i
b
_
,
and let I = 0 if no passage is observed at any jump time. We also introduce
U =
_
I if I = 0,
N
T
+ 1 if I = 0.
4.2 Zero-coupon bonds 16
We can now evaluate Equation (12) conditioned on the outcome of the simulated
jumps. We obtain with
BB
b
(j) =
BB
b
(X

j1
, X

,
j
) and b = log(d/v
0
)

(0, T) = IE
_
1
{>T}
e
rT
+ R1
{T}
e
r
|F

= R
_
U

i=1
i1

j=1

BB
b
(j)
_

i

i1
e
rs
g
i
(s)ds +1
{I=0}
e
r
I
I

j=1

BB
b
(j)
_
+1
{I=0}
e
rT
N
T
+1

j=1

BB
b
(j). (14)
Algorithm 4.1 (Monte Carlo pricing of zero-coupon bonds)
Choose the number of simulation runs K and estimate (0, T) as
(0, T)
1
K
K

n=1

n
(0, T),
where each

n
(0, T) is calculated as described in Equation (14).
Let us remark that evaluating
_
e
rs
g
i
(s)ds is computationally expensive, due to
the complicated structure of the function g
i
. Metwally and Atiya 2002 propose
a Taylor approximation of the integral in r which can be integrated analytically
after some algebraic manipulations. We compared a numerical integration with
their Taylor approximation and found that, at least for reasonable and hence small
interest rates, the second approach is only marginally biased downward but signif-
icantly faster.
4.2.3 Zero-coupon bond pricing via Laplace transform
In this approach, we approximate the Riemann-Stieltjes integral of Equation (12)
as a simple Riemann-Stieltjes sum, where the integrator is evaluated at the points
of the partition using the inverse Laplace method described in Algorithm 3.2.
Algorithm 4.2 (Laplace pricing of zero-coupon bonds)
Partition the interval [0, T] equidistant with mesh T/n and use Algorithm 3.2 to
calculate the respective probabilities of default within two points of the partition.
The price of the bond is then approximated via
(0, T) = e
rT
IP( > T) + R
_
T
0
e
rt
dIP( t)
e
rT
IP( > T) + R
n

j=1
e
r
j0.5
n
T
IP
_

_
(j 1)T
n
,
jT
n
__
. (15)
4.3 Credit spreads for small maturities 17
Table 6.2 provides a comparison of zero-coupon bond prices computed with Algo-
rithm 4.1 and Algorithm 4.2 for dierent parameters.
4.2.4 The credit spread of a zero-coupon bond
The credit spread of a zero-coupon bond with maturity T is dened to be the
real number
T
that solves the relation
(0, T) = e
(r+
T
)T
. (16)
0 1 2 3 4 5
Time to Maturity
0
.
0
0
0
.
0
2
0
.
0
4
0
.
0
6
0
.
0
8
0
.
1
0
C
r
e
d
it

S
p
r
e
a
d
Figure 2: Spreads with and w/o jumps
For both, the pure and the jump-
diusion model we can calculate credit
spreads from the respective pricing for-
mulae. Typical term structures of credit
spreads are given in Figure 2. As
parameters for the jump diusion, we
choose = .02 , = .05 , p = .5 ,
= 2 ,

= 20 , d/v
0
= 90%,
R = 42% and r = .02 . The parameters
for the pure diusion X
D
t
=
D
t+
D
W
t
are chosen such that
D
= IE[X
1
] and

2
D
= Var(X
1
) to provide comparable results. We observe that unlike in the
pure diusion model, credit spreads for small maturities do not vanish in a jump-
diusion model. Heuristically, this is due to the possibility of a default-triggering
downward jump, even for small maturities. This feature of our model is discussed
more detailed in the next section.
4.3 Credit spreads for small maturities
In the presence of negative jumps, the rst-passage time is no longer a predictable
stopping time. A detailed discussion of this issue can be found in Jarrow and
Protter 2004. Therefore, we assume that credit spreads in our model do not vanish
as time to maturity tends to zero. A less theoretical approach to the same pre-
sumption is simply to compute the term structure of credit spreads in our model
and to observe the positive limit of credit spreads at zero, as we did in Figure 2.
This feature of our model coincides with real credit spreads and xes the often
criticized small credit spreads for small maturities in a pure diusion model. In
what follows, we will even derive the exact limit of credit spreads in our model.
4.3 Credit spreads for small maturities 18
4.3.1 The local default rate of
In all structural credit-risk models, the conditional probability that default occurs
within h units of time tends to zero as h does. This limit is even independent of
the information on which the computation of the conditional probability is based.
What distinguishes our model from pure diusion models is the rate of convergence
given full information F. In a pure diusion model, we apply Equation (7) and
lHospitals rule and observe for a solvent company with x
t
= log (d/V
t
)
lim
h0
1
h
IP( t + h|F
t
) = lim
h0
1
h
_

_
x
t
h

h
_
+ e
2xt
2

_
x
t
+ h

h
__
= 0.
(17)
In pure diusion models, this fact forces credit spreads of zero-coupon bonds to
tend to zero as maturity decreases to zero; compare Due and Lando 2000. In
our model we obtain a positive limit which only depends on the parameters of the
jump component and the distance to default.
Theorem 4.1 (The local default rate of )
At any time t 0 , the distance to default for X is given by x
t
= log (d/V
t
) .
Based on full information F, we obtain for > t
lim
h0
1
h
IP( t + h|F
t
) = (1 p) (d/v
0
)

Xt
= (1 p)e

xt
, IP-a.s.
Proof: X has independent and stationary increments, hence
IP( t + h|F
t
) = IP
_
inf
0sh
X
t+s
X
t
x
t

F
t
_
= IP(X
h
x
t
) , IP-a.s.
This justies that we may consider w.l.o.g. the limiting behavior of
1
h
IP( h) .
We condition on the number of jumps that occurred up to time h and obtain
lim
h0
1
h
IP( h) = lim
h0
1
h
IP
_
inf
0sh
s + W
s
+
Ns

j=1
Y
j
x
0
_
= lim
h0
1
h

n=0
IP(N
h
= n)IP
_
X
h
x
0

N
h
= n
_
.
The following conditional probabilities are examined separately. We condition on
the events that up to time h , we observe either no jump, exactly one jump or more
then one jump. For the case N
h
= 1 , we even condition on whether the jump is
positive or negative. This yields
. . . = lim
h0
e
h
h
IP
_
inf
0sh
s + W
s
x
0
_
4.3 Credit spreads for small maturities 19
+ lim
h0
pe
h
IP
_
inf
0sh
s + W
s
+ 1
{s
1
}
Y
1
x
0

N
h
= 1, Y
1
> 0
_
+ lim
h0
(1 p)e
h
IP
_
inf
0sh
s + W
s
+1
{s
1
}
Y
1
x
0

N
h
= 1, Y
1
< 0
_
+ lim
h0
1
h

n=2
e
h
(h)
n
n!
IP
_
inf
0sh
s + W
s
+
Ns

j=1
Y
j
x
0

N
h
= n
_
.
We saw in Equation (17) that the rst limit is zero, and obviously so is the sec-
ond. Considering the last limit, a dominated convergence argument allows us to
interchange limit and summation, establishing that this limit also equals zero. Let
us now examine the third limit, the case of one negative jump. We approximate
this probability from below by assuming that default can only occur at h . An
upper bound is derived by adding the negative jump already at time zero. More
precisely, we have
IP
_
h + W
h
Y

x
0
_
IP
_
inf
0sh
s + W
s
1
{s
1
}
Y

x
0

N
h
= 1
_
IP
_
inf
0sh
s + W
s
Y

x
0
_
.
The sequence of events A
h
= { : inf
0sh
s + W
s
Y

x
0
} is
decreasing in h . Therefore, by continuity of the probability measure we obtain for
the limit of upper bounds
lim
h0
IP(A
h
) = IP(A
0
) = IP(Y

x
0
) = e

x
0
.
To show that the sequence of lower bounds has the same limit, we make use of
Equation (B12) of Kou 2002 and Lemma 4.1 of Kou and Wang 2003. We let
=

, = (

h)
1
, =

and c = (x
t
+ h) and obtain
lim
h0
IP(h + W
h
Y

x
t
) = lim
h0
_
1

2
e
1
2

2
h
2

I
0
(c; ; ; )
_
=
lim
h0
_
1

2
e
1
2

2
h
2

e
c

Hh
0
(c ) +

+

2
2
2
(c + +

)
__
=
lim
h0
_
1

2
e
1
2

2
h
2

2e
c

(c ) +

+

2
2
2
(c + +

)
__
=
. . . replace , , , c and let h tend to 0 . . . = e

xt
.
4.4 The limit of credit spreads at the short end of the term structure 20
0.0 0.2 0.4 0.6 0.8 1.0
Time
9
0
9
5
1
0
0
1
0
5
1
1
0
Default Threshold
Asset Values
0.0 0.2 0.4 0.6 0.8 1.0
Time
0
.
1
0
.
2
0
.
3
0
.
4
L
o
c
a
l
D
e
f
a
u
lt

R
a
t
e
Figure 3: A sample path of V and the corresponding local default rate of .
As parameters, we choose = .02 , = .05 , p = .5 , = 2 and

= 30 .
4.4 The limit of credit spreads at the short end of the term
structure
In the next theorem, we calculate the limit of credit spreads in our jump-diusion
model as time to maturity decreases to zero. This limit is found using the local
default rate of , which allows us to write IP( (0, ds]) = (1p) exp(

x
0
)ds .
Theorem 4.2 (Credit spreads at zero)
We let

= (1 p)e

x
0
and obtain
lim
h0

h
=

(1 R).
Proof: We obtain from Equation (16) and lHospitals rule
lim
h0

h
= lim
h0

1
h
log
_
e
rh
p(0, h) + R
_
h
0
e
rs
p(0, ds)
_
r
= lim
h0

1
h
log
_
e
rh
(1

h) + R
_
h
0
e
rs

ds
_
r
= lim
h0
re
rh
(1

h) +

e
rh
Re
rh

e
rh
(1

h) + R
_
h
0
e
rs
ds
r
=

(1 R).
21
5 Calibration of the model
We now discuss an approach on how parameter estimates can be obtained from
market data for a given company. We denote the issued bonds of this company
by B
1
, . . . , B
n
. For each bond B
i
, we obtain model prices B
M
i
from Equation
(11) that depend on the set of parameters (, , ,

, p) . The idea of our

calibration is to choose the parameters such that model prices agree with market
prices. More precisely, we seek to minimize the sum of squared distances of model
to market prices. This estimate can be interpreted as the markets agreement of
the parameters. We obtain the minimization problem
_
, ,

, p
_
= argmin
n

i=1
_
B
i
B
M
i
_
2
.
All other parameters that occur in the pricing formula are obtained either from
current market data, from publications of the company, or are estimated a priori.
5.1 Numerical details
Our optimization problem is to minimize a function of several variables with un-
known partial derivatives. The parameters show functional dependence and dif-
ferent local minima make this computation dicult. Time needed to evaluate
the sum of squared dierences for a set of parameters depends heavily on the
accuracy of the Laplace inversion algorithm. We obtained a good performance
by gradually increasing this accuracy. The numerical routine of our choice is
nag opt bounds no deriv of the NAG software packet.
5.2 Setup and results
We slightly modify the pricing formulae (11) and (15), replacing the constant
risk-free interest r by a deterministic risk-free yield curve r
t
. This yield curve
is obtained from market prices of Bundesanleihen, as published by Stuttgarts
stock exchange
1
for maturities t {0, . . . , 10} . We interpolate linearly for non-
integer maturities. Companies publish their debt-to-value ratio every quarter; we
obtained current numbers from Bloomberg. As recovery rates, one can either use
estimates which are published by dierent rating agencies or historical values. In
our analysis, we rely on historical numbers as published by Altman and Kishore
1996. We run an estimation for DaimlerChrysler and General Motors; the results
are presented in the next section.
1
www.boerse-stuttgart.de
5.2 Setup and results 22
5.2.1 Setup and results for DaimlerChrysler (DCX)
Bond quotes are obtained from Stuttgarts stock exchange; all prices include broken-
period interest. Quotation date is 25.08.2005, 1pm. As input parameters we use
a debt-to-value ratio of d/v
0
= 82.3913%. This ratio is obtained from DCXs
balance sheet of the second quarter 2005. Altman and Kishore 1996 report an
average recovery rate of 41%, averaged over all industrial sectors. Considering the
business structure of DCX and reported recoveries for dierent industries, we felt
we should choose R for DCX a notch higher, so we let R = 42%. The risk-free
yield curve r
t
is obtained from Bundesanleihen. Using this setup, we obtain
Table 1: Estimated parameters for DCX
p

14
i=1
(B
M
i
B
i
)
2
.004449 .020260 .476894 .852775 35.7906 28.5123 .390455
Table 2: Model and market prices: DCX
WKN Coupon Maturity Model Price Market Price Dierence
369293 4.625 10.03.2006 103.306861 103.19 -.001132
611867 6.125 21.03.2006 104.712257 104.67 -.000404
689080 5.625 06.07.2006 103.498493 103.42 -.000759
A0DB7Z 2.000 05.09.2006 101.547979 101.54 -.000079
907882 3.750 02.10.2006 104.799059 104.73 -.000659
829942 5.625 16.01.2007 107.656132 107.46 -.001825
A0DHP3 2.475 16.03.2007 101.017892 101.22 .001997
851890 6.125 27.03.2007 108.038199 107.80 -.002210
A0BD90 2.608 02.07.2007 100.416606 100.78 .003606
A0DZP6 3.125 10.03.2008 102.317418 102.39 .000709
765013 3.750 04.06.2008 103.311009 103.19 -.001173
A0ACD4 4.125 23.01.2009 106.146911 106.19 .000406
611868 7.000 21.03.2011 121.048224 120.84 -.001723
A0DDFR 4.250 04.10.2011 107.844546 108.02 .001624
The dierence is calculated as (Market Price-Model Price)/Market Price .
5.2 Setup and results 23
5.2.2 Setup and results for General Motors (GM)
The setup and data sources for GM are as those of DCX. GM reports in 2/2005 a
debt-to-value ratio of d/v
0
= 94.47131%. We again choose R = 42%. The list of
bonds used to estimate the parameters is given below, omitting bonds in currencies
other than Euro and longer times to maturity. We obtain
Table 3: Estimated parameters for GM
p

20
i=1
(B
M
i
B
i
)
2
-.003913 .012313 .505527 .373096 96.5989 38.3502 2.497470
Table 4: Model and market prices: GM
WKN Coupon Maturity Model Price Market Price Dierence
183098 7.000 15.11.2005 106.142388 106.21 .000637
291815 4.000 09.02.2006 102.234274 102.48 .002398
610260 5.750 14.02.2006 103.897810 104.15 .002421
776306 4.174 03.03.2006 102.130616 102.22 .000874
A0BC23 2.625 14.06.2006 99.430427 99.43 -.000004
908510 4.375 26.09.2006 104.190749 104.50 .002959
748413 6.000 16.10.2006 107.077676 107.15 .000675
A0DACL 3.040 15.02.2007 99.598528 98.60 -.010127
850892 6.125 15.03.2007 105.091735 105.23 .001314
A0E8A5 4.125 02.06.2007 99.988892 100.45 .004590
A0E7D3 5.625 13.07.2007 102.130365 102.16 .000290
819413 4.750 16.07.2007 100.433439 100.22 -.002130
A0DCTX 2.923 14.09.2007 98.939518 99.27 .003329
A0DG6B 3.674 03.12.2007 99.648395 99.45 -.001995
894454 6.000 03.07.2008 101.925706 101.32 -.005978
905302 3.920 12.09.2008 98.760729 98.76 -.000007
A0BEAR 3.429 30.06.2009 90.925046 91.51 .006392
A0DCTY 4.750 14.09.2009 98.718413 98.60 -.001201
908511 5.750 27.09.2010 100.522887 100.24 -.002822
A0AWBL 5.375 06.06.2011 93.247923 93.43 .001949
The dierence is calculated as (Market Price-Model Price)/Market Price .
5.2 Setup and results 24
5.2.3 A note on the results of the estimation
We rst observe the excellent tting capability of our model, both for small and long
maturities. For all bonds, the dierence of model to market prices is below bid-ask
spreads. The estimated parameters for DCX (resp. GM) correspond to IE[X
1
] =
.000166 and Var(X
1
) = .001277 (resp. IE[X
1
] = .006771 and Var(X
1
) =
.000297 ). It is interesting to notice that the total variance of X
t
is explained to
32.15% (resp. 51.00%) by the diusion, the jump component accounting for the
remainder. This indicates that including jumps in a traditional diusion model is
a realistic and useful generalization. The diusion component explains the long-
term behavior of credit spreads, while the jump component corrects unrealistically
small credit spreads for small maturities.
25
6 Numerical examples
6.1 Passage probabilities of the jump diusion X
The following table compares the Monte Carlo simulation of Algorithm 3.1 with
the inverse Laplace transform of Algorithm 3.2. The Monte Carlo simulation is
based on 100,000 simulation runs, the inverse Laplace transform is evaluated up to
summand n = 9 . We x p = .5 and = .05 and vary the remaining parameters;
the threshold is chosen to be b = .2 . Let us remark that in the upper part of
the table, where

= 2 , the jumps dominate the overall variance, compare

Equation (3), while in the lower part with

= 30 the diusion component

is dominant.
Table 5: Calculated and simulated passage probabilities IP(
b
> t)
Eq. (7) Alg. 3.1 Alg. 3.2 Alg. 3.1 Alg. 3.2

= 2

= 2 = 0 = .05 = .05 = 3 = 3
= .05 t = 1 .999999 .983693 .983353 .488645 .489167
t = 5 .999746 .934113 .933801 .223129 .225705
= .2 t = 1 .756894 .747532 .746222 .421392 .421267
t = 5 .512585 .491378 .491614 .193907 .192604

= 30

= 30 = 0 = .05 = .05 = 3 = 3
= .05 t = 1 .999999 .999884 .999895 .983211 .983234
t = 5 .999746 .999294 .999355 .922313 .922913
= .2 t = 1 .756894 .756055 .756314 .723714 .723888
t = 5 .512585 .511517 .511945 .477441 .476614
6.2 Estimated and approximated bond prices 26
6.2 Estimated and approximated bond prices
In this table, we compare the Monte Carlo method 4.1 with the inverse Laplace ap-
proximation 4.2 for pricing a zero-coupon bond with face value one. Additionally,
we calculate treasury and pure diusion prices from Equation (13). As parameters
for the value process of the underlying company, we choose = .02 , = .05
and R = 50%. The risk-free interest rate is assumed to be r = .02 . Each Monte
Carlo simulation is based on 100,000 simulation runs; the integrals
_
g
i
(s)e
rs
ds
are numerically evaluated using the NAG routine d01ajc. The Laplace inver-
sion is performed up to summand n = 9 ; the integral in the pricing formula is
approximated with a mesh of 1/100 .
Table 6: Estimated and approximated zero-coupon bond prices
Treasury Eq. (13) Alg. 4.1 Alg. 4.2 Alg. 4.1 Alg. 4.2

= 2

= 2 e
rt
= 0 = .05 = .05 = 3 = 3
d
v
0
= .8 t = 1 .980199 .980198 .972334 .972181 .733749 .734532
t = 5 .904837 .902314 .870844 .870890 .579972 .579859
d
v
0
= .9 t = 1 .980199 .973264 .963313 .963445 .701662 .702112
t = 5 .904837 .852492 .822096 .821632 .567019 .566023

= 30

= 30 e
rt
= 0 = .05 = .05 = 3 = 3
d
v
0
= .8 t = 1 .980199 .980198 .980142 .980149 .972087 .972141
t = 5 .904837 .902314 .901643 .901612 .840852 .840733
d
v
0
= .9 t = 1 .980199 .973264 .971927 .972038 .904750 .905834
t = 5 .904837 .852492 .849456 .849276 .730477 .730540
References 27
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References 28
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Address for correspondence:
Matthias Scherer
University of Ulm - Department of Financial Mathematics
Faculty of Mathematics and Economics
Helmholtzstr. 18
89069 Ulm, Germany
Phone: +49-731-5023517, Fax: +49-731-5031096
mscherer@mathematik.uni-ulm.de