Credit Risk V.

T.R. Bielecki, M. Jeanblanc and M. Rutkowski

MLV, M2 Janvier 2007
1
V. Hedging of credit derivatives
1. Two default free assets, one defaultable asset
1.1 Two default free assets, one total default asset
1.2 Two default free assets, one defaultable with recovery
2. Two defaultable assets
2
Two default-free assets, one defaultable asset
Two default-free assets, one defaultable asset
We present a particular case where there are two default-free assets
the savings account with constant interest rate r
An asset with dynamics
dY
2
t
= Y
2
t
(
t
dt +
t
dW
t
)
where the coecients
t
,
t
are F-adapted processes
a defaultable asset
dY
3
t
= Y
3
t
(
3,t
dt +
3,t
dW
t
+
3,t
dM
t
) ,
where the coecients
3
,
3
,
3
are G-adapted processes with
3
1.
5
Two default-free assets, one defaultable asset
Our aim is to hedge defaultable claims. As we shall establish, the case
of total default for the third asset (i.e.
3,t
1) is really dierent
from the others.
6
Two default-free assets, a total default asset
Two default-free assets, a total default asset
We assume that
dY
3
t
= Y
3
t
(
3,t
dt +
3,t
dW
t
dM
t
) .
Y
3
t
=

Y
3
t
11
t<
.
dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 7
Two default-free assets, a total default asset
Here, our aim is to hedge survival claims (X, 0, ), i.e. contingent
claims of the form X11
T<
where X F
T
.
The price of the contingent claim is
C
t
= e
r(Tt)
E
Q
(X11
T<
|G
t
)
The hedging strategy consists of a triple
1
,
1
,
3
such that

3
t
Y
3
t
= C
t
,
1
t
e
rt
+
2
t
Y
t
= 0
and which satises the self nancing condition.
dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 10
PDE Approach
PDE Approach
We are working in a model with constant (or Markovian) coecients
dY
t
= Y
t
rdt
dY
2
t
= Y
2
t
(
2
dt +
2
dW
t
)
dY
3
t
= Y
3
t
(
3
dt +
3
dW
t
dM
t
) .
Let C(t, Y
2
t
, Y
3
t
, H
t
) be the price of the contingent claim G(Y
2
T
, Y
3
T
, H
T
)
and

be the risk-neutral intensity of default.

dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 12
PDE Approach
Then,

t
C(t, y
2
, y
3
; 0) +ry
2

2
C(t, y
2
, y
3
; 0) + ry
3

3
C(t, y
2
, y
3
; 0) rC(t, y
2
, y
3
; 0)
+
1
2
3

i,j=2

j
y
i
y
j

ij
C(t, y
2
, y
3
; 0) +

C(t, y
2
, 0; 1) = 0
where r = r +

and

t
C(t, y
2
; 1) +ry
2

2
C(t, y
2
; 1) +
1
2

2
2
y
2
2

22
C(t, y
2
; 1) rC(t, y
2
; 1) = 0
with the terminal conditions
C(T, y
2
, y
3
; 0) = G(y
2
, y
3
; 0), C(T, y
2
; 1) = G(y
2
, 0; 1).
dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 15
PDE Approach
The replicating strategy for Y is given by formulae

3
t
Y
3
t
= C(t) = C(t, Y
2
t
, 0; 1) +C(t, Y
2
t
, Y
3
t
; 0)

2
t
Y
2
t
= C(t) +
3

i=2
Y
i
t

i
C(t)

1
t
Y
1
t
= C(t)
2
t
Y
2
t

3
t
Y
3
t
.
Note that, in the case of survival claim, C(t, Y
2
t
, 0; 1) = 0 and

3
t
Y
3
t
= C(t, Y
2
t
, Y
3
t
; 0) for every t [0, T]. Hence, the following
relationships holds, for every t < ,

3
t
Y
3
t
= C(t, Y
2
t
, Y
3
t
; 0),
1
t
Y
1
t
+
2
t
Y
2
t
= 0.
The last equality is a special case of the balance condition. It
ensures that the wealth of a replicating portfolio falls to 0 at default
time.
dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 19
PDE Approach
Example 1
Consider a survival claim Y = 11
{T<}
g(Y
2
T
). Its pre-default pricing
function C(t, y
2
, y
3
; 0) = C
g
(t, y
2
) where C
g
solves

t
C
g
(t, y; 0) +ry
2
C
g
(t, y; 0) +
1
2

2
2
y
2

22
C
g
(t, y; 0) rC
g
(t, y; 0) = 0
C
g
(T, y; 0) = g(y)
The solution is
C
g
(t, y) = e
(rr)(tT)
C
r,g,2
(t, y) = e
(tT)
C
r,g,2
(t, y),
where C
r,g,2
is the price of an option with payo g(Y
T
) in a BS model
with interest rate r and volatility
2
.
dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 20
PDE Approach
Example 2
Consider a survival claim of the form
Y = G(Y
2
T
, Y
3
T
, H
T
) = 11
{T<}
g(Y
3
T
).
Then the post-default pricing function C
g
( ; 1) vanishes identically,
and the pre-default pricing function C
g
( ; 0) is
C
g
(t, y
2
, y
3
; 0) = C
r,g,3
(t, y
3
)
where C
,g,3
(t, y) is the price of the contingent claim g(Y
T
) in the
Black-Scholes framework with the interest rate and the volatility
parameter equal to
3
.
dY
1
= Y
1
rdt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW dM) 21
Two default-free assets, one defaultable asset with Recovery, PDE approach
Two default-free assets, one defaultable asset with
Recovery, PDE approach
Let the price processes Y
1
, Y
2
, Y
3
satisfy
dY
1
t
= rY
1
t
dt
dY
2
t
= Y
2
t
(
2
dt +
2
dW
t
)
dY
3
t
= Y
3
t
(
3
dt +
3
dW
t
+
3
dM
t
)
with
2
= 0. Assume that the relationship
2
(r
3
) =
3
(r
2
)
holds and
3
= 0,
3
> 1. Then the price of a contingent claim
Y = G(Y
2
T
, Y
3
T
, H
T
) can be represented as
t
(Y ) = C(t, Y
2
t
, Y
3
t
; H
t
),
where the pricing functions C( ; 0) and C( ; 1) satisfy the following
PDEs
dY
1
= rY
1
dt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW +
3
dM) 23
Two default-free assets, one defaultable asset with Recovery, PDE approach

t
C(t, y
2
, y
3
; 1) +ry
2

2
C(t, y
2
, y
3
; 1) +ry
3

3
C(t, y
2
, y
3
; 1) rC(t, y
2
, y
3
; 1)
+
1
2
3

i,j=2

j
y
i
y
j

ij
C(t, y
2
, y
3
; 1) = 0
and

t
C(t, y
2
, y
3
; 0) +ry
2

2
C(t, y
2
, y
3
; 0) +y
3
(r
3
)
3
C(t, y
2
, y
3
; 0)
rC(t, y
2
, y
3
; 0) +
1
2
3

i,j=2

j
y
i
y
j

ij
C(t, y
2
, y
3
; 0)
+
_
C(t, y
2
, y
3
(1 +
3
); 1) C(t, y
2
, y
3
; 0)
_
= 0
subject to the terminal conditions
C(T, y
2
, y
3
; 0) = G(y
2
, y
3
, 0), C(T, y
2
, y
3
; 1) = G(y
2
, y
3
, 1).
dY
1
= rY
1
dt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW +
3
dM) 26
Two default-free assets, one defaultable asset with Recovery, PDE approach
The replicating strategy equals = (
1
,
2
,
3
)

2
t
=
1

3
Y
2
t
_

3
3

i=2

i
y
i

i
C(t, Y
2
t
, Y
3
t
, H
t
)

3
_
C(t, Y
2
t
, Y
3
t
(1 +
3
); 1) C(t, Y
2
t
, Y
3
t
; 0)
__
,

3
t
=
1

3
Y
3
t
_
C(t, Y
2
t
, Y
3
t
(1 +
3
); 1) C(t, Y
2
t
, Y
3
t
; 0)
_
,
and where
1
t
is given by
1
t
Y
1
t
+
2
t
Y
2
t
+
3
t
Y
3
t
= C
t
.
dY
1
= rY
1
dt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW +
3
dM) 27
Two default-free assets, one defaultable asset with Recovery, PDE approach
Example Consider a survival claim of the form
Y = G(Y
2
T
, Y
3
T
, H
T
) = 11
{T<}
g(Y
3
T
).
Then the post-default pricing function C
g
( ; 1) vanishes identically,
and the pre-default pricing function C
g
( ; 0) solves

t
C
g
( ; 0) + ry
2

2
C
g
( ; 0) +y
3
(r
3
)
3
C
g
( ; 0)
+
1
2
3

i,j=2

j
y
i
y
j

ij
C
g
( ; 0) (r +)C
g
( ; 0) = 0
C
g
(T, y
2
, y
3
; 0) = g(y
3
)
Denote = r
3
and = (1 +
3
).
Then, C
g
(t, y
2
, y
3
; 0) = e
(Tt)
C
,g,3
(t, y
3
) where C
,g,3
(t, y) is the
price of the contingent claim g(Y
T
) in the Black-Scholes framework with
the interest rate and the volatility parameter equal to
3
.
dY
1
= rY
1
dt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW +
3
dM) 28
Two default-free assets, one defaultable asset with Recovery, PDE approach
Let C
t
be the current value of the contingent claim Y , so that
C
t
= 11
{t<}
e
(Tt)
C
,g,3
(t, y
3
).
The hedging strategy of the survival claim is, on the event {t < },

3
t
Y
3
t
=
1

3
e
(Tt)
C
,g,3
(t, Y
3
t
) =
1

3
C
t
,

2
t
Y
2
t
=

3

2
_
Y
3
t
e
(Tt)

y
C
,g,3
(t, Y
3
t
)
3
t
Y
3
t
_
.
dY
1
= rY
1
dt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW +
3
dM) 29
Two default-free assets, one defaultable asset with Recovery, PDE approach
Hedging of a Recovery Payo
The price C
g
of the payo G(Y
2
T
, Y
3
T
, H
T
) = 11
{T}
g(Y
2
T
) solves

t
C
g
( ; 1) +ry
y
C
g
( ; 1) +
1
2

2
2
y
2

yy
C
g
( ; 1) rC
g
( ; 1) = 0
C
g
(T, y; 1) = g(y)
hence C
g
(t, y
2
, y
3
, 1) = C
r,g,2
(t, y
2
) is the price of g(Y
2
T
) in the model
Y
1
, Y
2
. Prior to default, the price of the claim solves

t
C
g
(; 0) + ry
2

2
C
g
( ; 0) +y
3
(r
3
)
3
C
g
( ; 0)
+
1
2
3

i,j=2

j
y
i
y
j

ij
C
g
( ; 0) (r +)C
g
( ; 0) = C
g
(t, y
2
; 1)
C
g
(T, y
2
, y
3
; 0) = 0
Hence C
g
(t, y
2
, y
3
; 0) = (1 e
(tT)
)C
r,g,2
(t, y
2
).
dY
1
= rY
1
dt, dY
2
= Y
2
(
2
dt +
2
dW), dY
3
= Y
3
(
3
dt +
3
dW +
3
dM) 30
Two defaultable assets with total default
Two defaultable assets with total default
Assume that Y
1
and Y
2
are defaultable tradeable assets with zero
recovery and a common default time .
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2
Then
Y
1
t
= 11
{>t}

Y
1
t
, Y
2
t
= 11
{>t}

Y
2
t
with
d

Y
i
t
=

Y
i
t
((
i
+
t
)dt +
i
dW
t
), i = 1, 2
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2 31
Two defaultable assets with total default
The wealth process V associated with the self-nancing trading strategy
(
1
,
2
) satises for t [0, T]
V
t
= Y
1
t
_
V
1
0
+
_
t
0

2
u
d

Y
2,1
u
_
where

Y
2,1
t
=

Y
2
t
/

Y
1
t
.
Obviously, this market is incomplete, however, some contingent
claims are hedgeable, as we present now.
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2 32
Two defaultable assets with total default
Hedging Survival claim: martingale approach
A strategy (
1
,
2
) replicates a survival claim C = X11
{>T}
whenever
we have

Y
1
T
_

V
1
0
+
_
T
0

2
t
d

Y
2,1
t
_
= X
for some constant

V
1
0
and some F-predictable process
2
.
It follows that if
1
=
2
, any survival claim C = X11
{>T}
is
attainable.
Let

Q be a probability measure such that

Y
2,1
t
is an F-martingale under

Q. Then the pre-default value

U
t
(C) at time t of (X, 0, ) equals

U
t
(C) =

Y
1
t
E
Q
_
X(

Y
1
T
)
1
| F
t
_
.
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2 33
Two defaultable assets with total default
Example: Call option on a defaultable asset We assume that
Y
1
t
= D(t, T) represents a defaultable ZC-bond with zero recovery, and
Y
2
t
= 11
{t<}

Y
2
t
is a generic defaultable asset with total default. The
payo of a call option written on the defaultable asset Y
2
equals
C
T
= (Y
2
T
K)
+
= 11
{T<}
(

Y
2
T
K)
+
The replication of the option reduces to nding a constant x and an
F-predictable process
2
that satisfy
x +
_
T
0

2
t
d

Y
2,1
t
= (

Y
2
T
K)
+
.
Assume that the volatility
1,t

2,t
of

Y
2,1
is deterministic. Let

F
2
(t, T) =

Y
2
t
(

D(t, T))
1
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2 34
Two defaultable assets with total default
The credit-risk-adjusted forward price of the option written on Y
2
equals

C
t
=

Y
2
t
N
_
d
+
(

F
2
(t, T), t, T)
_
K

D(t, T)N
_
d

F
2
(t, T), t, T)
_
,
where
d

f, t, T) =
ln

f ln K
1
2
v
2
(t, T)
v(t, T)
and
v
2
(t, T) =
_
T
t
(
1,u

2,u
)
2
du.
Moreover the replicating strategy in the spot market satises for
every t [0, T], on the set {t < },

1
t
= KN
_
d

F
2
(t, T), t, T)
_
,
2
t
= N
_
d
+
(

F
2
(t, T), t, T)
_
.
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2 35
Two defaultable assets with total default
Hedging Survival claim: PDE approach
Assume that
1
=
2
. Then the pre-default pricing function v satises
the PDE

t
C +y
1
_

1
+
1

2

1

2

1
_

1
C +y
2
_

2
+
2

2

1

2

1
_

2
C
+
1
2
_
y
2
1

2
1

11
C +y
2
2

2
2

22
C + 2y
1
y
2

12
C
_
=
_

1
+
1

2

1

2

1
_
C
with the terminal condition C(T, y
1
, y
2
) = G(y
1
, y
2
).
dY
i
t
= Y
i
t
(
i
dt +
i
dW
t
dM
t
), i = 1, 2 36