Four-factor model of Quanto CDS with jumps-at-default and stochastic recovery

Abstract

In this paper we modify the model of Itkin et al. (2019), proposed for pricing Quanto Credit Default Swaps (CDS) and risky bonds, in several ways. First, it is known since the Lehman Brothers bankruptcy that the recovery rate could significantly vary right before or at default, therefore, in this paper we consider it to be stochastic. Second, to reduce complexity of the model, we treat the domestic interest rate as deterministic, because, as shown in Itkin et al. ( 2019), volatility of the domestic interest rate does not contribute much to the value of the Quanto CDS spread. Finally, to solve the corresponding systems of 4D partial differential equations we use a different flavor of the Radial Basis Function (RBF) method which is a combination of localized RBF and finitedifference methods, and is known in the literature as RBF-FD. Results of our numerical experiments presented in the paper demonstrate that the influence of volatility of the recovery rate is significant if the correlation between the recovery rate and the log-intensity of the default is non-zero. Also, the impact of the recovery mean-reversion rate on the Quanto CDS spread could be significant and comparable with the impact due to jump-at-default in the FX rate.