Modeling credit spreads with the Cheyette model and its application to credit default swaptions

Kalina Natcheva-Acar, Sarp Kaya Acar, Martin Krekel

Abstract

ABSTRACT

In this paper we apply Cheyette's Markov representation of the Heath-Jarrow-Morton framework to the modeling of stochastic credit spreads. As an application of this framework, the volatility of the credit spread process is modeled by considering the constant elasticity of variance approach of Ritchken and Sankarasubramanian and the Andersen-Andreasen displaced approach. To examine the practicability of this approach, we calibrate the model to market prices of credit default swaptions. Thereby we use Monte Carlo simulation and the alternating direction implicit finite-difference method.