RISK PREMIA AND OPTIMAL LIQUIDATION OF CREDIT DERIVATIVES

Abstract

This paper studies the optimal timing to liquidate credit derivatives in a general intensity-based credit risk model under stochastic interest rate. We incorporate the potential price discrepancy between the market and investors, which is characterized by risk-neutral valuation under different default risk premia specifications. We quantify the value of optimally timing to sell through the concept of delayed liquidation premium, and analyze the associated probabilistic representation and variational inequality. We illustrate the optimal liquidation policy for both single-name and multi-name credit derivatives. Our model is extended to study the sequential buying and selling problem with and without short-sale constraint.