A model-insensitive determination of First-hitting-time densities with Application to Equity default-swaps

TL;DR

This paper introduces a model-insensitive method for estimating first-hitting-time densities, enhancing robustness in pricing equity default-swaps, especially for out-of-the-money barriers, without relying on specific stochastic process models.

Contribution

It proposes a novel, model-insensitive approach for determining first-hitting-time densities, improving robustness in equity default-swap pricing for extreme barriers.

Findings

Method provides robust first-hitting-time estimates for out-of-the-money barriers.

Applicable to conservative pricing of equity default-swaps.

Outperforms model-dependent approaches in certain scenarios.

Abstract

Equity default-swaps pay the holder a fixed amount of money when the underlying spot level touches a (far-down) barrier during the life of the instrument. While most pricing models give reasonable results when the barrier lies within the range of liquidly traded strikes of plain-vanilla option prices, the situation is more involved for extremely out-of-the money barriers. In this paper we discuss a model-insensitive approach for the determination of first hitting times that does not rely on the full a priori knowledge of the stochastic process for the price dynamics. Hence more robust pricing and hedging results are expected as a result of this analysis. In contrast to stochastic volatility-models our approach is well suited for the conservative pricing of equity default-swaps.