Paper detail

Killed Brownian motion with a prescribed lifetime distribution and models of default

The inverse first passage time problem asks whether, for a Brownian motion $B$ and a nonnegative random variable $ζ$, there exists a time-varying barrier $b$ such that $\mathbb{P}\{B_s>b(s),0\leq s\leq t\}=\mathbb{P}\{ζ>t\}$. We study a "smoothed" version of this problem and ask whether there is a "barrier" $b$ such that $ \mathbb{E}[\exp(-λ\int_0^tψ(B_s-b(s))\,ds)]=\mathbb{P}\{ζ>t\}$, where $λ$ is a killing rate parameter, and $ψ:\mathbb{R}\to[0,1]$ is a nonincreasing function. We prove that if $ψ$ is suitably smooth, the function $t\mapsto \mathbb{P}\{ζ>t\}$ is twice continuously differentiable, and the condition $0<-\frac{d\log\mathbb{P}\{ζ>t\}}{dt}<λ$ holds for the hazard rate of $ζ$, then there exists a unique continuously differentiable function $b$ solving the smoothed problem. We show how this result leads to flexible models of default for which it is possible to compute expected values of contingent claims.