Credit Risk, II.

T.R. Bielecki, M. Jeanblanc and M. Rutkowski

MLV, November 2006 2006
1
II. Hazard Process Approach: A Toy Model
1. The Model
2. Toy Model and Martingales
3. Valuation and Trading Defaultable Claims
2
The Model
3
The Market
We begin with the case where a riskless asset, with deterministic
interest rate (r(s); s 0) is the only asset available in the default-free
market.
R(t) = exp
_

_
t
0
r(s)ds
_
4
The Market
We begin with the case where a riskless asset, with deterministic
interest rate (r(s); s 0) is the only asset available in the default-free
market.
R(t) = exp
_

_
t
0
r(s)ds
_
The time-t price B(t, T) of a risk-free zero-coupon bond with maturity
T is
B(t, T)
def
= exp
_

_
T
t
r(s)ds
_
.
5
Default occurs at time , where is assumed to be a positive random
variable with density f, constructed on a probability space (, G, P).
F(t) = P( t) =
_
t
0
f(s)ds .
We assume that F(t) < 1, t
6
Defaultable Zero-coupon with Payment at Maturity
A defaultable zero-coupon bond (DZC in short)- or a corporate
bond- with maturity T and rebate paid at maturity, consists of
The payment of one monetary unit at time T if default has not
occurred before time T,
A payment of monetary units, made at maturity, if < T, where
0 < 1.
7
Value of the defaultable zero-coupon bond
The value of the defaultable zero-coupon bond is dened as
D
(,T)
(0, T) = E
_
B(0, T) (11
{T<}
+11
{T}
)
_
= B(0, T) (1 (1 )F(T)) .
8
Value of the defaultable zero-coupon bond
The value of the defaultable zero-coupon bond is dened as
D
(,T)
(0, T) = E
_
B(0, T) (11
{T<}
+11
{T}
)
_
= B(0, T) (1 (1 )F(T)) .
The value D
(,T)
(t, T) of the DZC is the conditional expectation of the
discounted payo B(t, T) [11
{T<}
+11
{T}
] given the information:
D
(,T)
(t, T) = 11
{t}
B(t, T) + 11
{t<}

D
(,T)
(t, T)
9
Value of the defaultable zero-coupon bond
The value of the defaultable zero-coupon bond is dened as
D
(,T)
(0, T) = E
_
B(0, T) (11
{T<}
+11
{T}
)
_
= B(0, T) (1 (1 )F(T)) .
The value D
(,T)
(t, T) of the DZC is the conditional expectation of the
discounted payo B(t, T) [11
{T<}
+11
{T}
] given the information:
D
(,T)
(t, T) = 11
{t}
B(t, T) + 11
{t<}

D
(,T)
(t, T)
where the predefault value

D
(,T)
(t, T) is dened as

D
(,T)
(t, T) = E
_
B(t, T) (11
{T<}
+11
{T}
)

t <
_
10

D
(,T)
(t, T) = E
_
B(t, T) (11
{T<}
+11
{T}
)

t <
_
11

D
(,T)
(t, T) = E
_
B(t, T) (11
{T<}
+11
{T}
)

t <
_
= B(t, T)
_
1 (1 )P( T

t < )
_
12

D
(,T)
(t, T) = E
_
B(t, T) (11
{T<}
+11
{T}
)

t <
_
= B(t, T)
_
1 (1 )P( T

t < )
_
= B(t, T)
_
1 (1 )
P(t < T)
P(t < )
_
13

D
()
(t, T) = E
_
B(t, T) (11
{T<}
+11
{T}
)

t <
_
= B(t, T)
_
1 (1 )P( T

t < )
_
= B(t, T)
_
1 (1 )
P(t < T)
P(t < )
_
= B(t, T)
_
1 (1 )
F(T) F(t)
1 F(t)
_
14
The formula

D
(,T)
(t, T) = B(t, T) B(t, T)(1 )
P(t < T)
P(t < )
can be read as

D
(,T)
(t, T) = B(t, T) EDLGD DP
15
The formula

D
(,T)
(t, T) = B(t, T) B(t, T)(1 )
P(t < T)
P(t < )
can be read as

D
(,T)
(t, T) = B(t, T) EDLGD DP
where the Expected Discounted Loss Given Default (EDLGD) is
dened as B(t, T)(1 ) and the Default Probability (DP) is
DP =
P(t < T)
P(t < )
= P( T|t < ) .
16
In case the payment is a function of the default time, say (), the
value of this defaultable zero-coupon is
D
(,T)
(0, T) = E
_
B(0, T) 11
{T<}
+B(0, T)()11
{T}
_
= B(0, T)
_
P(T < ) +
_
T
0
(s)f(s)ds
_
.
17
In case the payment is a function of the default time, say (), the
value of this defaultable zero-coupon is
D
(,T)
(0, T) = E
_
B(0, T) 11
{T<}
+B(0, T)()11
{T}
_
= B(0, T)
_
P(T < ) +
_
T
0
(s)f(s)ds
_
.
The predefault price

D
(,T)
(t, T) is

D
(,T)
(t, T) = B(t, T)E( 11
{T<}
+()11
{T}

t < )
= B(t, T)
_
P(T < )
P(t < )
+
1
P(t < )
_
T
t
(s)f(s)ds
_
.
18
We introduce the increasing hazard function dened by
(t) = ln(1 F(t))
and its derivative (t) =
f(t)
1 F(t)
where f(t) = F

(t), i.e.,
1 F(t) = e
(t)
= exp
_

_
t
0
(s)ds
_
= P( > t) .
19
We introduce the increasing hazard function dened by
(t) = ln(1 F(t))
and its derivative (t) =
f(t)
1 F(t)
where f(t) = F

(t), i.e.,
1 F(t) = e
(t)
= exp
_

_
t
0
(s)ds
_
= P( > t) .
The quantity (t) called the hazard rate is the probability that the
default occurs in a small interval dt given that the default has not
occured before time t
(t) = lim
h0
1
h
P( t +h| > t) .
20
For = 0,

D(t, T) = exp
_

_
T
t
(r +)(s)ds
_
in other terms, the spot rate has to be adjusted by means of a spread
() in order to evaluate DZCs.
21
Defaultable Zero-coupon with Payment at Hit
Here, a defaultable zero-coupon bond with maturity T consists of
The payment of one monetary unit at time T if default has not yet
occurred,
A payment of () monetary units, where is a deterministic
function, made at time if < T.
Here, we do not assume that F is dierentiable.
22
Value of the defaultable zero-coupon
The value of this defaultable zero-coupon bond is
D
()
(0, T) = E(B(0, T) 11
{T<}
+B(0, )()11
{T}
)
= G(T)B(0, T)
_
T
0
B(0, s)(s)dG(s) ,
where G(t) = 1 F(t) = P(t < ) is the survival probability.
23
For t < T,
D
()
(t, T) = 11
t<

D
()
(t, T)
where

D
()
(t, T) is called the predefault price dened by
B(0, t)

D
()
(t, T) = E(B(0, T) 11
{T<}
+B(0, )()11
{T}
|t < )
=
P(T < )
P(t < )
B(0, T) +
1
P(t < )
_
T
t
B(0, s)(s)dF(s) .
Hence,
B(0, t)G(t)

D
()
(t, T) = G(T)B(0, T)
_
T
t
B(0, s)(s)dG(s) .
24
In terms of the hazard function, the time-t value

D
()
(t, T) satises:
B(0, t)e
(t)

D
()
(t, T) = e
(T)
B(0, T) +
_
T
t
B(0, s)e
(s)
(s)d(s) .
25
A particular case If F is dierentiable, the function =

satises
f(t) = (t)e
(t)
. Then,
R
d
(t)

D
()
(t, T) = R
d
(T) +
_
T
t
R
d
(s)(s)(s)ds
with
R
d
(t) = exp
_

_
t
0
(r(s) +(s)) ds
_
The defaultable interest rate is r + and is, as expected, greater than r
(the value of a DZC with = 0 is smaller than the value of a
default-free zero-coupon).
26
The dynamics of

D
()
(t, T) are
d

D
()
(t, T) = (r(t) +(t))

D
()
(t, T)dt (t)(t)dt .
The dynamics of D
()
includes a jump at time .
27
Spreads
A term structure of credit spreads associated with the zero-coupon
bonds S(t, T) is dened as
S(t, T) =
1
T t
ln
D(t, T)
B(t, T)
.
In our setting, on the set { > t}
S(t, T) =
1
T t
ln Q

( > T| > t) ,
whereas S(t, T) = on the set { t}.
28
Toy Model and Martingales
We denote by (H
t
, t 0) the right-continuous increasing process
H
t
= 11
{t}
and by (H
t
) its natural ltration. Any integrable
H
t
-measurable r.v. H is of the form
H = h( t) = h()11
{t}
+h(t)11
{t<}
where h is a Borel function.
29
Key Lemma
If X is any integrable, G-measurable r.v.
E(X|H
t
)11
{t<}
= 11
{t<}
E(X11
{t<}
)
P(t < )
.
30
Key Lemma
If X is any integrable, G-measurable r.v.
E(X|H
t
)11
{t<}
= 11
{t<}
E(X11
{t<}
)
P(t < )
.
Let Y = h() be a H-measurable random variable. Then
E(Y |H
t
) = 11
{t}
h() + 11
{t<}
_

t
h(u)e
(t)(u)
d(u)
31
An important Martingale
The process (M
t
, t 0) dened as
M
t
= H
t

_
t
0
dF(s)
1 F(s)
= H
t

_
t
0
(1 H
s
)
dF(s)
1 F(s)
is a H-martingale.
32
Hazard Function
The hazard function is
(t) = ln(1 F(t)) =
_
t
0
dF(s)
1 F(s)
In particular, if F is dierentiable, the process
M
t
= H
t

_
t
0
(s)ds = H
t

_
t
0
(s)(1 H
s
)ds
is a martingale, where (s) =
f(s)
1 F(s)
is a deterministic non-negative
function, called the intensity of .
33
The Doob-Meyer decomposition of the submartingale H
t
is
H
t
= M
t
+ (t )
The predictable process A
t
=
t
is called the compensator of H.
34
The process
L
t
def
= 11
{>t}
exp
_
_
t
0
(s)ds
_
is a H-martingale.
35
Proof: We shall give 3 dierent arguments, each of which constitutes a
proof.
a) Since the function is deterministic, for t > s
E(L
t
|H
s
) = exp
_
_
t
0
(u)du
_
E(11
{t<}
|H
s
) .
From the Key Lemma
E(11
{t<}
|H
s
) = 11
{>s}
1 F(t)
1 F(s)
= 11
{>s}
exp ((t) + (s)) .
Hence,
E(L
t
|H
s
) = 11
{>s}
exp
_
_
s
0
(u)du
_
= L
s
.
36
b) Another method is to apply integration by parts formula to the
process L
t
= (1 H
t
) exp
_
_
t
0
(s)ds
_
If U and V are two nite
variation processes, Stieltjes integration by parts formula can be
written as follows
U(t)V (t) = U(0)V (0) +
_
]0,t]
V (s)dU(s) +
_
]0,t]
U(s)dV (s)
+

st
U(s) V (s) .
dL
t
= dH
t
exp
_
_
t
0
(s)ds
_
+(t) exp
_
_
t
0
(s)ds
_
(1 H
t
)dt
= exp
_
_
t
0
(s)ds
_
dM
t
.
37
c) A third (sophisticated) method is to note that L is the exponential
martingale of M, i.e., the solution of the SDE
dL
t
= L
t
dM
t
, L
0
= 1.

38
In the case where N is an inhomogeneous Poisson process with
deterministic intensity and is the rst time when N jumps, let
H
t
= N
t
. It is well known that N
t

_
t
0
(s)ds is a martingale (see
Appendix). Therefore, the process stopped at time is also a
martingale, i.e., H
t

_
t
0
(s)ds is a martingale.
39
Change of probability
Let P

be a probability equivalent to P on the space (, H) where

H = H

is the -algebra generated by . Then,

dP

= h() dP
where h is a strictly positive fonction, such that E
P
(h()) = 1. Let
g(t) = e
(t)
E
P
(11
t<
h()) .
If is continuous,

is continuous and
d

(t) =
h(t)
g(t)
d(t)
40
Proof:
P

( t) = E
P
(11
t<
h()) =
_

t
h(u)dF(u) = e

(t)
Hence
e

(t)
d

(t) = h(t)dF(t) = h(t)e

(t)
d(t)
Therefore
E
P
(11
t<
h())d

(t) = h(t)e
(t)
d(t)
It follows that
d

(t) =
h(t)
e
(t)
E
P
(11
t<
h())
d(t) =
h(t)
g(t)
d(t)
41
Exercices: Let
t
= E
P
(h()|H
t
). Prove that

t
=
_
t
0
h(s)dH
s
+ (1 H
t
)g(t)
Prove that the martingale admits a representation in terms of M as

t
= 1 +
_
t
0
(h(u)
u
)dM
u
and that an explicit representation is

t
= (1 + 11
t
k()) exp
_

_
t
0
k(u)d(u)
_
where k(t) =
h(t)
g(t)
1
42
Incompleteness of the Toy model
If the market consists only of the risk-free zero-coupon bond, there
exists innitely many e.m.ms. The discounted asset prices are
constant, hence the set Q of equivalent martingale measures is the set
of probabilities equivalent to the historical one. For any Q Q, we
denote by F
Q
the cumulative function of under Q, i.e.,
F
Q
(t) = Q( t) .
43
The range of prices is dened as the set of prices which do not induce
arbitrage opportunities. For a DZC with a constant rebate paid at
maturity, the range of prices is equal to the set
{E
Q
(B(0, T)(11
{T<}
+11
{<T}
)), Q Q} .
This set is exactly the interval ]R
T
, R
T
[.
44
Risk Neutral Probability Measures
It is usual to interpret the absence of arbitrage opportunities as the
existence of an e.m.m. . If DZCs are traded, their prices are given by
the market, and the equivalent martingale measure Q, chosen by the
market, is such that, on the set {t < },
D(t, T) = B(t, T)E
Q
_
[11
T<
+11
t<T
]

t <
_
.
Therefore, we can characterize the cumulative function of under Q
from the market prices of the DZC as follows.
45
Zero Recovery If a DZC with zero recovery of maturity T is traded at
a price D(t, T) which belongs to the interval ]0, R
t
T
[ , then, under any
risk-neutral probability Q, the process R(t)D(t, T) is a martingale, the
following equality holds
D(t, T)B(0, t) = E
Q
(B(0, T)11
{T<}
|H
t
) = B(0, T)11
{t<}
exp
_

_
T
t

Q
(s)ds
_
where
Q
(s) =
dF
Q
(s)/ds
1 F
Q
(s)
. The process
Q
is the Q-intensity of .
Therefore the unique risk-neutral intensity can be obtained from the
prices of DZCs as
r(t) +
Q
(t) =
T
ln D(t, T)|
T=t
46
Fixed Payment at maturity If the prices of DZCs with dierent
maturities are known, then )
B(0, T) D(0, T)
B(0, T)(1 )
= F
Q
(T)
where F
Q
(t) = Q( t), so that the law of is known under the
e.m.m..
47
Payment at hit In this case, denoting by
T
D the derivative of the
value of the DZC at time 0 with respect to the maturity, we obtain

T
D(0, T) = g(T)B(0, T) G(T)B(0, T)r(T) (T)g(T)B(0, T) ,
where g(t) = G

(t). Therefore, solving this equation leads to

Q( > t) = G(t) = (t)
_
1 +
_
t
0

T
D(0, s)
1
B(0, s)(1 (s))
((s))
1
ds
_
,
where (t) = exp
_
_
t
0
r(u)
1 (u)
du
_
.
48
Representation Theorem
Let h be a (bounded) Borel function. Then, the martingale
M
h
t
= E(h()|H
t
) admits the representation
E(h()|H
t
) = E(h())
_
t
0
(

h(s) h(s)) dM
s
,
where M
t
= H
t
(t ) and

h(s) =
_

t
h(u)dG(u)
G(t)
.
49
Representation Theorem
Let h be a (bounded) Borel function. Then, the martingale
M
h
t
= E(h()|H
t
) admits the representation
E(h()|H
t
) = E(h())
_
t
0
(

h(s) h(s)) dM
s
,
where M
t
= H
t
(t ) and

h(s) =
_

t
h(u)dG(u)
G(t)
.
Note that

h(s) = M
h
s
on s < .
50
Representation Theorem
Let h be a (bounded) Borel function. Then, the martingale
M
h
t
= E(h()|H
t
) admits the representation
E(h()|H
t
) = E(h())
_
t
0
(

h(s) h(s)) dM
s
,
where M
t
= H
t
(t ) and

h(s) =
_

t
h(u)dG(u)
G(t)
.
Note that

h(s) = M
h
s
on s < .
In particular, any square integrable H-martingale (X, t 0) can be
written as X
t
= X
0
+
_
t
0
x
s
dM
s
where (x
t
, t 0) is a predictable process.
51
Proof: A proof consists in computing the conditional expectation
E(h()|H
t
) = h()H
t
+ (1 H
t
)e
(t)
_

t
h(s)dF(s)
and to use integration by parts formula.
52
Partial information: Due and Landos model
Due and Lando study the case where = inf{t : V
t
m} where V
satises
dV
t
= (t, V
t
)dt +(t, V
t
)dW
t
.
53
Partial information: Due and Landos model
Due and Lando study the case where = inf{t : V
t
m} where V
satises
dV
t
= (t, V
t
)dt +(t, V
t
)dW
t
.
Here the process W is a Brownian motion. If the information is the
Brownian ltration, the time is a stopping time w.r.t. a Brownian
ltration, therefore is predictable and admits no intensity.
54
Partial information: Due and Landos model
Due and Lando study the case where = inf{t : V
t
m} where V
satises
dV
t
= (t, V
t
)dt +(t, V
t
)dW
t
.
Here the process W is a Brownian motion. If the information is the
Brownian ltration, the time is a stopping time w.r.t. a Brownian
ltration, therefore is predictable and admits no intensity. If the agent
does not know the behavior of V , but only the minimal information H
t
,
i.e. he knows when the default appears, the price of a zero-coupon is, in
the case where the default is not yet occurred, exp
_

_
T
t
(s)ds
_
where (s) =
f(s)
G(s)
and G(s) = P( > s), f = G

, as soon as the
cumulative function of is dierentiable.
55
Valuation and Trading Defaultable Claims
56
We assume that the market has chosen a riskneutral probability Q and
that M and are computed w.r.t. Q. We assume here that the interest
rate r is constant.
57
We assume that the market has chosen a riskneutral probability Q and
that M and are computed w.r.t. Q. We assume here that the interest
rate r is constant.
Price dynamics of a survival claim (X, 0, ).
Let (X, 0, ) be a survival claim. The price of the payo 11
{T<}
X that
settles at time T is
Y
t
= e
rt
E
Q
(11
{T<}
e
rT
X| H
t
).
58
We assume that the market has chosen a riskneutral probability Q and
that M and are computed w.r.t. Q. We assume here that the interest
rate r is constant.
Price dynamics of a survival claim (X, 0, ).
Let (X, 0, ) be a survival claim. The price of the payo 11
{T<}
X that
settles at time T is
Y
t
= e
rt
E
Q
(11
{T<}
e
rT
X| H
t
).
The dynamics of the price process is
dY
t
= rY
t
dt Y
t
dM
t
=
_
r + 11
{t<}
(t)
_
Y
t
dt Y
t
dH
t
.
59
Price dynamics of a recovery claim (0, Z, ).
The recovery Z is paid at the time of default. The cum-dividend price
process Y of (0, Z, ) is
Y
t
= e
rt
E
Q
(11
{T}
e
r
Z() | H
t
) ,
60
Price dynamics of a recovery claim (0, Z, ).
The recovery Z is paid at the time of default. The cum-dividend price
process Y of (0, Z, ) is
Y
t
= e
rt
E
Q
(11
{T}
e
r
Z() | H
t
) ,
and
dY
t
= rY
t
dt + (Z(t) Y
t
) dM
t
=
_
r + 11
{t<}
(t)
_
Y
t
dt 11
{t<}
Z(t)(t) dt + (Z(t) Y
t
) dH
t
.
61
Price dynamics of a recovery claim (0, Z, ).
The recovery Z is paid at the time of default. The cum-dividend price
process Y of (0, Z, ) is
Y
t
= e
rt
E
Q
(11
{T}
e
r
Z() | H
t
) ,
and
dY
t
= rY
t
dt + (Z(t) Y
t
) dM
t
=
_
r + 11
{t<}
(t)
_
Y
t
dt 11
{t<}
Z(t)(t) dt + (Z(t) Y
t
) dH
t
.
The ex-dividend price is
S
t
= e
rt
E
Q
(11
{T>t}
e
r
Z() | H
t
) = Y
t
e
rt
Z()e
r
11
{t}
.
62
Price dynamics of a recovery claim (0, Z, ).
The recovery Z is paid at the time of default. The cum-dividend price
process Y of (0, Z, ) is
Y
t
= e
rt
E
Q
(11
{T}
e
r
Z() | H
t
) ,
and
dY
t
= rY
t
dt + (Z(t) Y
t
) dM
t
=
_
r + 11
{t<}
(t)
_
Y
t
dt 11
{t<}
Z(t)(t) dt + (Z(t) Y
t
) dH
t
.
The ex-dividend price is
S
t
= e
rt
E
Q
(11
{T>t}
e
r
Z() | H
t
) = Y
t
e
rt
Z()e
r
11
{t}
. Hence
dS
t
= (rS
t
Z(t)(t))dt (S
t
Z(t))dM
t
.
63
Valuation of a Credit Default Swap
A credit default swap (CDS) is a contract between two counterparties.
B agrees to pay a default payment Z to A if a default of the obligor C
occurs. If there is no default until the maturity of the default swap, B
pays nothing. A pays a fee for the default protection. The fee can be
either a fee paid till the maturity or till the default event.
64
A can not cancelled the contract. He can at any time before the default
transfer the contract to D: D will pay the fee and receive the default
payment if any. As we shall see, it can happen that D will require an
amount of cash to accept to receive the contract. Usually, the fee
consists of C
i
paid at time T
i
(this is the xed leg). However, here we
shall consider a continuous payment. The default payment is called the
default leg.
65
A stylized credit default swap is formally introduced through the
following denition.
A credit default swap with a constant spread and recovery at
default is a defaultable claim (0, C, Z, ), where Z
t
(t) and
C
t
= t for every t [0, T]. An RCLL function : [0, T] IR
represents the protection payment and a constant IR is termed
the spread (or the premium) of a CDS.
66
For simplicity, we assume that the interest rate r = 0, so that the price
of a savings account B
t
= 1 for every t. Our results can be easily
extended to the case of a constant r.
67
Ex-dividend Price of a CDS
The ex-dividend price of a CDS maturing at T with spread is given
by the formula
S
t
() = E
Q

_
()11
{t<T}
11
{t<}

_
( T) t
_

H
t
_
.
68
Ex-dividend Price of a CDS
The ex-dividend price of a CDS maturing at T with spread is given
by the formula
S
t
() = E
Q

_
()11
{t<T}
11
{t<}

_
( T) t
_

H
t
_
.
The ex-dividend price at time t [s, T] of a credit default swap with
spread and recovery at default equals
S
t
() = 11
{t<}
1
G(t)
_

_
T
t
(u) dG(u)
_
T
t
G(u) du
_
.
69
Proof: We have, on the set {t < },
S
t
() =
_
T
t
(u) dG(u)
G(t)

_

_
T
t
udG(u) +TG(T)
G(t)
t
_
=
1
G(t))
_

_
T
t
(u) dG(u)
_
TG(T) tG(t)
_
T
t
udG(u)
_
_
.
It remains to note that
_
T
t
G(u) du = TG(T) tG(t)
_
T
t
udG(u),

70
The ex-dividend price of a CDS can also be represented as follows
S
t
() = 11
{t<}

S
t
(), t [0, T],
where

S
t
() stands for the ex-dividend pre-default price of a CDS.
71
Market CDS Spreads
Assume now that a CDS was initiated at some date s t and its initial
price was equal to zero. A market CDS started at s is a CDS initiated
at time s whose initial value is equal to zero. A T-maturity CDS market
spread at time s is the level of the spread = (s, T) that makes a
T-maturity CDS started at s worthless at its inception. A CDS market
spread at time s is thus determined by the equation S
s
((s, T)) = 0.
72
The T-maturity market spread (s, T) is a solution to the equation
_
T
s
(u) dG(u) +(s, T)
_
T
s
G(u) du = 0,
and thus for every s [0, T],
(s, T) =
_
T
s
(u) dG(u)
_
T
s
G(u) du
.
73
Standing assumptions. We x the maturity date T, and we write
briey (s) instead of (s, T). In addition, we assume that all credit
default swaps have a common recovery function .
Note that the ex-dividend pre-default value at time t [0, T] We have
the following result, in which the quantity (t, s) = (t) (s)
represents the calendar CDS market spread (for a given maturity T).
74
The ex-dividend price of a market CDS started at s with recovery at
default and maturity T equals, for every t [s, T],
S
t
((s)) = 11
{t<}
((t) (s))
_
T
t
G(u) du
G(t)
= 11
{t<}
(t, s)
_
T
t
G(u) du
G(t)
,
or more explicitly,
S
t
((s)) = 11
{t<}
_
T
t
G(u) du
G(t)
_
_
T
s
(u) dG(u)
_
T
s
G(u) du

_
T
t
(u) dG(u)
_
T
t
G(u) du
_
.
75
Price Dynamics of a CDS
In what follows, we assume that
G(t) = Q( > t) = exp
_

_
t
0
(u) du
_
where the default intensity (t) under Q is deterministic. We rst focus
on the dynamics of the ex-dividend price of a CDS with spread
started at some date s < T.
76
The dynamics of the ex-dividend price S
t
() on [s, T] are
dS
t
() = S
t
() dM
t
+ (1 H
t
)( (t)(t)) dt,
where the H-martingale M under Q is given by the formula
M
t
= H
t

_
t
0
(1 H
u
)(u) du, t IR
+
.
77
Proof: It suces to recall that
S
t
() = 11
{t<}

S
t
() = (1 H
t
)

S
t
()
so that
dS
t
() = (1 H
t
) d

S
t
()

S
t
() dH
t
.
Using the explicit expression of

S
t
, we nd easily that we have
d

S
t
() = (t)

S
t
() dt + ((s) (t)(t)) dt.
The SDE for S follows.
78
Trading Strategies with a CDS
A strategy
t
= (
0
t
,
1
t
), t [0, T], is self-nancing if the wealth process
U(), dened as
U
t
() =
0
t
+
1
t
S
t
(),
satises
dU
t
() =
1
t
dS
t
() +
1
t
dD
t
,
where S() is the ex-dividend price of a CDS with the dividend stream
D. A strategy replicates a contingent claim Y if U
T
() = Y .
79
Hedging of a Contingent Claim in the CDS Market
Our aim is to nd a replicating strategy for the defaultable claim
(X, 0, Z, ), where X is a constant and Z
t
= z(t).
80
Hedging of a Contingent Claim in the CDS Market
Our aim is to nd a replicating strategy for the defaultable claim
(X, 0, Z, ), where X is a constant and Z
t
= z(t).
Let y and
1
be dened as
y(t) =
1
G(t)
_
_
t
0
z(s)dG(s) +XG(T)
_

1
(t) =
z(t) y(t)
(t)

S
t
()
,
81
Hedging of a Contingent Claim in the CDS Market
Our aim is to nd a replicating strategy for the defaultable claim
(X, 0, Z, ), where X is a constant and Z
t
= z(t).
Let y and
1
be dened as
y(t) =
1
G(t)
_
_
t
0
z(s)dG(s) +XG(T)
_

1
(t) =
z(t) y(t)
(t)

S
t
()
,
Let
0
t
= V
t
()
1
(t)S
t
(), where V
t
() = E
Q
(Y |H
t
) and
Y = 11
{T}
z() + 11
{T<}
X
82
Hedging of a Contingent Claim in the CDS Market
Our aim is to nd a replicating strategy for the defaultable claim
(X, 0, Z, ), where X is a constant and Z
t
= z(t).
Let y and
1
be dened as
y(t) =
1
G(t)
_
_
t
0
z(s)dG(s) +XG(T)
_

1
(t) =
z(t) y(t)
(t)

S
t
()
,
Let
0
t
= V
t
()
1
(t)S
t
(), where V
t
() = E
Q
(Y |H
t
) and
Y = 11
{T}
z() + 11
{T<}
X
Then the self-nancing strategy = (
0
,
1
) based on the savings
account and the CDS is a replicating strategy.
83
Proof: The terminal value of the wealth is
Y = z()11
{<T}
+X11
{T<}
84
Proof: The terminal value of the wealth is
Y = z()11
{<T}
+X11
{T<}
On the one hand
E(Y |H
t
) = Y
t
= z()11
{t}
+ 11
{<t}
1
G(t)
_
XG(T) +
_
t
0
z(s)dG(s)
_
=
_
t
0
z(s)dH
s
+ (1 H
t
)
1
G(t)
_
XG(T) +
_
t
0
z(s)dG(s)
_
85
Proof: The terminal value of the wealth is
Y = z()11
{<T}
+X11
{T<}
On the one hand
E(Y |H
t
) = Y
t
= z()11
{t}
+ 11
{<t}
1
G(t)
_
XG(T) +
_
t
0
z(s)dG(s)
_
=
_
t
0
z(s)dH
s
+ (1 H
t
)
1
G(t)
_
XG(T) +
_
t
0
z(s)dG(s)
_
hence dY
t
= (z(t) y(t)) dM
t
with y(t) =
1
G(t)
(
_
t
0
z(s)dG(s) +XG(T)).
86
Proof: The terminal value of the wealth is
Y = z()11
{<T}
+X11
{T<}
On the one hand
E(Y |H
t
) = Y
t
= z()11
{t}
+ 11
{<t}
1
G(t)
_
XG(T) +
_
t
0
z(s)dG(s)
_
=
_
t
0
z(s)dH
s
+ (1 H
t
)
1
G(t)
_
XG(T) +
_
t
0
z(s)dG(s)
_
hence dY
t
= (z(t) y(t)) dM
t
with y(t) =
1
G(t)
(
_
t
0
z(s)dG(s) +XG(T)).
On the other hand,
dY
t
=
1
t
(dS
t
() (1 H
t
)dt +(t)dH
t
) =
1
t
((t) S
t
()) dM
t
.
87