Market implied volatilities for defaultable bonds

Abstract

Typically, implied volatilities for defaultable instruments are not available in the financial market since quotations related to options on defaultable bonds or on credit default swaps are usually not quoted by brokers. However, an estimate of their volatilities is needed for pricing purposes. In this paper, we provide a methodology to infer market implied volatilities for defaultable bonds using equity implied volatilities and CDS spreads quoted by the market in relation to a specific issuer. The theoretical framework we propose is based on the Merton’s model under stochastic interest rates where the short rate is assumed to follow the Hull–White model. A numerical analysis is provided to illustrate the calibration process to be performed starting from financial market data. The market implied volatility calibrated according to the proposed methodology could be used to evaluate options where the underlying is a risky bond, i.e. callable bond or other types of credit-risk sensitive financial instruments.

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Notes

  1. 1.

    Data related to the Debt securities statistics published by the Bank for International Settlements, www.bis.org.

  2. 2.

    See Black and Scholes (1973) and Merton (1974).

  3. 3.

    The Merton model assumes the following: (1) there is an overly simple debt structure, (2) there are no bankruptcy costs (i.e., the liquidation value equals the firm value), and (3) the debt and equity are frictionless tradable assets.

  4. 4.

    An alternative formulation of the Hull–White model can be used where the short rate is expressed as \(r(t) = \alpha (t) + x(t)\). See Russo and Fabozzi (2016) for further details.

  5. 5.

    See Crosbie and Bohn (1997) for further details.

  6. 6.

    For all quantities observed in the market we use the suffix M.

  7. 7.

    See Lando (1998).

  8. 8.

    An alternative approach could be adopted using, directly, prices of zero-coupon defaultable bonds (if they exist for the relevant issuer) in place of CDS quotations. Our decision to use CDS in place of bonds because of the fact that CDS are quoted in a standardized and liquid market while defaultable bond quotations are not always available for the desired maturity and sometimes they are not liquid.

  9. 9.

    Market data were obtained from Datastream.

  10. 10.

    Statistics we calculate are the following: average (Mean), standard deviation (Std), skewness (Skew), Kurtosis (Kurt), minimum (Min), and maximum (Max).

  11. 11.

    We have referred to RiskMetrics technical documentation RiskMetrics (1996) for theoretical framework and used a smoothing parameter equal to 0.94.

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Correspondence to Rosella Giacometti.

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Russo, V., Giacometti, R. & Fabozzi, F.J. Market implied volatilities for defaultable bonds. Ann Oper Res 275, 669–683 (2019). https://doi.org/10.1007/s10479-018-3064-z

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Keywords

  • Defaultable bonds’ implied volatility
  • Credit default swap (CDS)
  • Merton model
  • Hull and White model