Five-factor Risk Pricing Model

This paper is to provide a model that can well fit with market data and that is also tractable to price financial products exposed to default risk. There are two variables we need to model: risk-free (spot) interest rate and credit spread. We use the three-factor model developed by Torben G Anderson [1] to model risk-free interest rate, which is featured by stochastic volatility, mean drift and jumps. Then the credit spread is modeled by a two-factor model developed by Bernd Schmid [15] in which an uncertainty index is added to the drift to make the model economically meaningful. And we will see how to price defaultable zero-coupon bond and two kinds of credit options under this model by transform analysis that is introduced by Darrel Duffie [8].