A Tree Model for Pricing Credit Default Swaps with Equity, Market and Default Risk

This article presents a trinomial tree model for pricing Credit Default Swaps (CDSs) on a defaultable zero-coupon bond with equity, market and default risk. Interest rates are assumed to follow a mean-reverting square root process. We generalize the reduced-form approach to include a constant elasticity of variance (CEV) process for equity prices prior to default, which is capable of reproducing the volatility smile observed in the empirical data. Based on the empirical results, we specify the default intensity as a function of the stock price and the interest rate. The correlation between interest rates and equity prices is also considered. Illustrative examples show the use of the model and numerical results explain the impact of different parameters on the prices of CDSs.