The effects of jump risks associated with the default rate on credit spreads

Abstract

This paper studies credit spreads when the default intensity is affected by jump risks. A simple pricing model for risky bonds is derived using Madan and Unal’s (2000) hybrid model approach where there exist jump risks associated with the factors of the default intensity. Numerical examples provide a comparison of credit spreads induced by jumps with those induced only by diffusive components. The longer the maturity of a bond, the greater is the impact of jumps. Numerical examples also show that the credit spreads for short-term bonds may be significantly overpredicted and those for long-term bonds may be significantly underpredicted if jumps are ignored.