Modelling Default Correlations in a Two-Firm Model with Dynamic Leverage Ratios

Carl Chiarella, Chi-Fai Lo and Ming Xi Huang
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Chi-Fai Lo: Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong

No 304, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This article provides a generalized two-firm model of default correlation, based on the structural approach that incorporates interest rate risk. In most structural models default is driven by the firms' asset dynamics. In this article, a two-firm model of default is instead driven by the dynamic leverage ratios, which combines the measure of risks of the firms' total liabilities and assets. This article investigates analytical methods and numerical tools to solve the two-dimensional first passage time problem with time-dependent parameters. We carry out a comparative analysis of the impact of model parameters and provide some insights of their effects on joint survival probabilities and default correlations.

Keywords: credit risk; default correlations; default probabilities; first passage time (search for similar items in EconPapers)
JEL-codes: C60 G13 G32 (search for similar items in EconPapers)
Pages: 73 pages
Date: 2012-03-01
New Economics Papers: this item is included in nep-bec and nep-rmg
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