A tree model for pricing credit spread options subject to equity, and market risk

This article presents a trinomial tree model for pricing American credit spread options (CSOs) on a defaultable zero-coupon bond with equity and market risk. Interest rates are assumed to follow a mean-reverting square root process. The reduced-form approach is generalized 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 in , the default intensity is specified as a function of the stock price and 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 CSOs.