Default Swap Games Driven by Spectrally Negative Levy Processes

TL;DR

This paper analyzes game-type credit default swaps using spectrally negative Levy processes, identifying equilibrium strategies and contract values through optimal stopping game theory.

Contribution

It introduces a novel framework for modeling default swap games with spectrally negative Levy processes, providing existence proofs and equilibrium analysis.

Findings

Existence of Nash equilibrium in default swap games.

Explicit equilibrium strategies derived for buyer and seller.

Numerical results illustrate effects of default risk on exercise timing.

Abstract

This paper studies game-type credit default swaps that allow the protection buyer and seller to raise or reduce their respective positions once prior to default. This leads to the study of an optimal stopping game subject to early default termination. Under a structural credit risk model based on spectrally negative Levy processes, we apply the principles of smooth and continuous fit to identify the equilibrium exercise strategies for the buyer and the seller. We then rigorously prove the existence of the Nash equilibrium and compute the contract value at equilibrium. Numerical examples are provided to illustrate the impacts of default risk and other contractual features on the players' exercise timing at equilibrium.