Bankruptcy, Counterparty Risk, and Contagion

Holger Kraft and Mogens Steffensen
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Holger Kraft: Fachbereich Mathematik, Universität Kaiserslautern
Mogens Steffensen: Department of Applied Mathematics and Statistics, University of Copenhagen

No 2006/03, FRU Working Papers from University of Copenhagen. Department of Economics. Finance Research Unit

Abstract: This paper provides a unifying framework for the modeling of various types of credit risks such as contagion effects. We argue that Markov chains can efficiently be used to tackle these problems. However, our approach is not limited to pricing problems with contagion. Other applications include the modeling of a more sophisticated default process of a firm. On the theoretical side, we derive pricing formulas for three building blocks that are generalizations of contingent claims studied in Lando (1998). These claims can be thought of as atoms forming the basis for all credit risky payments. Furthermore, we demonstrate that, in general, all contingent claims exposed to credit risk satisfy a system of partial differential equations. This is the key result to calculate prices of credit risky claims explicitly and efficiently.

Keywords: default risk; financial distress; default correlation; contagion; Markov chains (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2006-05
New Economics Papers: this item is included in nep-cba, nep-cfn, nep-fin, nep-fmk and nep-rmg
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Citations: View citations in EconPapers (4)

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