Influence of jump-at-default in IR and FX on Quanto CDS prices

TL;DR

This paper introduces a comprehensive model for pricing Quanto CDS and risky bonds that incorporates four stochastic factors and jump-at-default features, providing insights into observed spread discrepancies.

Contribution

The paper develops a novel 4-factor model with jumps-at-default in FX and foreign interest rates, solved via a localized RBF method, advancing quantitative pricing techniques.

Findings

Model explains spread discrepancies between domestic and foreign markets

Numerical solutions effectively handle high-dimensional PDEs

Jump features significantly impact pricing accuracy

Abstract

We propose a new model for pricing Quanto CDS and risky bonds. The model operates with four stochastic factors, namely: hazard rate, foreign exchange rate, domestic interest rate, and foreign interest rate, and also allows for jumps-at-default in the FX and foreign interest rates. Corresponding systems of PDEs are derived similar to how this is done in Bielecki at al., 2005. A localized version of the RBF partition of unity method is used to solve these 4D PDEs. The results of our numerical experiments presented in the paper qualitatively explain the discrepancies observed in the marked values of CDS spreads traded in domestic and foreign economies.