Time-changed CIR default intensities with two-sided mean-reverting jumps

Abstract

The present paper introduces a jump-diffusion extension of the classical diffusion default intensity model by means of subordination in the sense of Bochner. We start from the bi-variate process $(X,D)$ of a diffusion state variable $X$ driving default intensity and a default indicator process $D$ and time change it with a Lévy subordinator $\mathcal{T}$. We characterize the time-changed process $(X^{\phi}_{t},D^{\phi}_{t})=(X(\mathcal{T}_{t}),D(\mathcal{T}_{t}))$ as a Markovian–Itô semimartingale and show from the Doob–Meyer decomposition of $D^{\phi}$ that the default time in the time-changed model has a jump-diffusion or a pure jump intensity. When $X$ is a CIR diffusion with mean-reverting drift, the default intensity of the subordinate model (SubCIR) is a jump-diffusion or a pure jump process with mean-reverting jumps in both directions that stays nonnegative. The SubCIR default intensity model is analytically tractable by means of explicitly computed eigenfunction expansions of relevant semigroups, yielding closed-form pricing of credit-sensitive securities.

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