GENERALISED STOCHASTIC DISCOUNT FACTORS FOR FELLER PROCESSES

Abstract

The stochastic discount factor of An(n) affine term structure models based on Feller processes can be generalised, while retaining tractability for valuing bonds, bond options and for survival probabilities in credit risk pricing. Bond yields and default intensities are non-linear and, under parameter restrictions, non-negative and monotonic in the Feller factors. Also bond risk premia and bond yields volatility are non-linear in the factors. The Cox-Ingersoll-Ross formula for discount bonds is generalised. The empirical evidence shows that these new models, when used for credit risk pricing, fit and predict sovereign credit default swap spreads significantly more accurately than the classic affine pricing model.