Multidimensional Structural Credit Modeling under Stochastic Volatility

This paper extends the structural credit model with underlying stochastic volatility to a multidimensional framework. The model combines the Black/Cox framework with the Heston model interpreting the equity of a company as a down-and-out barrier call option on the company's assets. This implies a combination of local and stochastic volatility on the equity as well as other stylized features. In this paper, we allow for a correlation between the asset processes of different companies to incorporate dependency structures. An estimator for the correlation parameter is derived and tested in a recovery framework. With the help of this model, we examine the default risk of the two mortgage lenders Fannie Mae and Freddie Mac before their actual placement into federal conservatorship and show that their default risk severely increased during the financial crisis.Peer Reviewe