Credit Risk Modeling

Credit risk modeling and CDS valuation

An analysis of structural models

Master thesis J.A.G. van Beem April, 2010

Credit risk modeling and CDS valuation

An analysis of structural models

A thesis

submitted in partial fulfillment of the requirements for the degree of Master of Science in Industrial Engineering and Management

University of Twente

by

Jeroen van Beem

Thesis Committee Dr. B. Roorda, University of Twente Dr. J. Krystul, University of Twente Dhr. K. Dessens, Deloitte Capital Markets

Abstract

The main objective of this thesis is to determine a credit risk model that could be used to value credit default swaps (CDSs). A literature study identifies that structural models are able to meet this objective and that they could also be used for analysis on default probabilities and recovery rates. Two structural models are selected for further research. In the first model the firm’s assets value process is a jump-diffusion process and default is modeled as the first-passage of a constant default barrier. The second model uses the same jump-diffusion process for the firm value, but incorporates a mean reverting leverage process to model default. We implement both models in Matlab using (Brownian Bridge) Monte Carlo simulations to analyze the sensitivity of modeled CDS term structures to value changes in the input parameters. We find that both models can calculate non-zero short-term CDS spreads and that the second model generates upward sloping term structures over a long time horizon. From three cases studies in which we compare modeled CDS spreads to the market spreads of Dutch firms we find that an advanced parameter estimation methodology is necessary to provide consistent jump and diffusion parameter values throughout the economic cycle.

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Preface

This is it. Although this preface might be the beginning of this master thesis for you, it is the end for me. It represents the end of long hours of working on this thesis, but also the...