Paper: arXiv 2303.12483

Authors: Giulia Livieri, Davide Radi, Elia Smaniotto

Abstract

Transition risk can be defined as the business-risk related to the enactment of green policies, aimed at driving the society towards a sustainable and low-carbon economy. In particular, the value of certain firms’ assets can be lower because they need to transition to a less carbon-intensive business model. In this paper we derive formulas for the pricing of defaultable coupon bonds and Credit Default Swaps to empirically demonstrate that a jump-diffusion credit risk model in which the downward jumps in the firm value are due to tighter green laws can capture, at least partially, the transition risk. The empirical investigation consists in the model calibration on the CDS term-structure, performing a quantile regression to assess the relationship between implied prices and a proxy of the transition risk. Additionally, we show that a model without jumps lacks this property, confirming the jump-like nature of the transition risk.

Complexity vs Empirical Score

  • Math Complexity: 7.0/10
  • Empirical Rigor: 7.5/10
  • Quadrant: Holy Grail — high math complexity, high empirical rigor

Why this score: This paper presents a strong combination of theoretical closed-form pricing derivations using jump-diffusion processes and practical empirical validation via CDS term-structure calibration and quantile regression. Demonstrating that transition risk exhibits explicit jump-like behavior provides a novel contribution to climate-finance credit risk modeling.

Research Flowchart

  flowchart TD
    A[Research Goal: Model & Prove Transition Risk in CDS Markets] --> B[Inputs: CDS Term-Structure Data & Green Policy Risk Proxies]
    B --> C[Derive Credit Risk Models: Jump-Diffusion vs No-Jump]
    C --> D[Calibrate Models to CDS Term-Structure]
    D --> E[Perform Quantile Regression on Implied Jump Prices]
    E --> F[Key Outcome: Jumps Successfully Capture Transition Risk; No-Jump Model Fails]