Optimal valuation of American callable credit default swaps under drawdown of Lévy insurance risk process

• Published in: Insurance, mathematics & economics Vol. 93; pp. 168 - 177
• Main Authors: Palmowski, Z., Surya, B.A.
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.07.2020; Elsevier Sequoia S.A
• Subjects: Assets; Convexity; Credit; Credit default swaps; Credit risk; Drawdown; Insurance; Insurance policies; Insurance premiums; Lévy process; Martingales; Optimization; Regularity; Stochastic processes; swaps; Uncertainty; Uniqueness; Valuation; Credit risk; swaps; Lévy process; Drawdown; Credit default swaps
• ISSN: 0167-6687; 1873-5959
• DOI: 10.1016/j.insmatheco.2020.04.011

This paper discusses the valuation of credit default swaps, where default is announced when the reference asset price has gone below certain level from the last record maximum, also known as the high-water mark or drawdown. We assume that the protection buyer pays premium at a fixed rate when the asset price is above a pre-specified level and continuously pays whenever the price increases. This payment scheme is in favour of the buyer as she only pays the premium when the market is in good condition for the protection against financial downturn. Under this framework, we look at an embedded option which gives the issuer an opportunity to call back the contract to a new one with reduced premium payment rate and slightly lower default coverage subject to paying a certain cost. We assume that the buyer is risk neutral investor trying to maximize the expected monetary value of the option over a class of stopping time. We discuss optimal solution to the stopping problem when the source of uncertainty of the asset price is modelled by Lévy process with only downward jumps. Using recent development in excursion theory of Lévy process, the results are given explicitly in terms of scale function of the Lévy process. Furthermore, the value function of the stopping problem is shown to satisfy continuous and smooth pasting conditions regardless of regularity of the sample paths of the Lévy process. Optimality and uniqueness of the solution are established using martingale approach for drawdown process and convexity of the scale function under Esscher transform of measure. Some numerical examples are discussed to illustrate the main results.