On Correlation and Default Clustering in Credit Markets

Antje Berndt, Peter Ritchken and Zhiqiang Sun

The Review of Financial Studies, 2010, vol. 23, issue 7, 2680-2729

Abstract: We establish Markovian models in the Heath, Jarrow, and Morton (1992) paradigm that permit an exponential affine representation of riskless and risky bond prices while offering significant flexibility in the choice of volatility structures. Estimating models in our family is typically no more difficult than in the workhorse affine family. Besides diffusive and jump-induced default correlations, defaults can impact the credit spreads of surviving firms, allowing for a greater clustering of defaults. Numerical implementations highlight the importance of incorporating interest rate--credit spread correlations, credit spread impact factors, and the full credit spread curve when building a unified framework for pricing credit derivatives. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Date: 2010
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