Dynamic Pricing of Credit Derivatives under Market Uncertainty: A Default-Risk Adjustment Model

Abstract

The static pricing model of credit default swaps (CDS) may not reflect the actual changes in the market due to capital flows and geopolitical conflicts at present, and thus will have a large valuation error. This paper extends a simplified reduced-form model by adding a Knightian uncertainty index to a jump-diffusion model of the default intensity and then builds a CDS pricing model with dynamic evolution of default risk. No-arbitrage pricing is used to find the equilibrium CDS spread, and the transmission from Knightian uncertainty to default intensity, expected default losses and CDS spread is explained. Based on the above theoretical analysis, a higher level of uncertainty will lead to a higher long-run default intensity, an increased expected loss from default, and thus a wider CDS spread. As the analysis is theoretical, the results of the reduction in pricing errors by the model should be regarded as a hypothesis. The following research will focus on the calibration and testing of the model with market data.