A SPREAD-RETURN MEAN-REVERTING MODEL FOR CREDIT SPREAD DYNAMICS

Abstract

In this paper, we propose a novel, analytically tractable, one-factor stochastic model for the dynamics of credit default swap (CDS) spreads and their returns, which we refer to as the spread-return mean-reverting (SRMR) model. The SRMR model can be seen as a hybrid of the Black–Karasinski model on spreads and the Ornstein–Uhlenbeck model on spread returns, and is able to capture empirically observed properties of CDS spreads and returns, including spread mean-reversion, heavy tails of the return distribution, and return autocorrelations. Although developed for modeling CDS spreads, the SRMR model has applications for many other stochastic processes with similar empirical properties, including more general rate processes.