Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model

Abstract.

We introduce the two-dimensional shifted square-root diffusion (SSRD) model for interest-rate and credit derivatives with (positive) stochastic intensity. The SSRD is the unique explicit diffusion model allowing an automatic and separated calibration of the term structure of interest rates and of credit default swaps (CDS’s), and retaining free dynamics parameters that can be used to calibrate option data. We propose a new positivity preserving implicit Euler scheme for Monte Carlo simulation. We discuss the impact of interest-rate and default-intensity correlation and develop an analytical approximation to price some basic credit derivatives terms involving correlated CIR processes. We hint at a formula for CDS options under CIR + + CDS-calibrated stochastic intensity.