Pricing credit spread options under a Markov chain model with Stochastic default rate

Abstract

This paper studies a Markov chain model that, unlike the existing models, has a stochastic default rate model so as to reflect real world phenomena. We extend the existing Markov chain models as follows: First, our model includes both the economy-wide and the rating-specific factors, which affect credit ratings. Second, our model allows both continuous and discrete movements in credit spreads, even when there exist no changes in credit ratings. Under these assumptions, we provide a valuation formula for a credit spread option, and examine its effects. This paper suggests a parsimonious model. As in J. Wei (2003), we find that rating-specific factors are important. Also, discrete movements seem to play a larger role depending on the firm's credit rating. Finally, we show that a model, like the Kodera model, that uses only a common factor without allowing for discrete movements, may overprice credit spread put options. (C) 2004 Wiley Periodicals, Inc.