CREDIT CONTAGION: PRICING CROSS-COUNTRY RISK IN BRADY DEBT MARKETS

Marco Avellaneda () and Lixin Wu ()
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Marco Avellaneda: Department of Mathematics, Courant Institute, New York University, NY 10012, USA
Lixin Wu: Department of Mathematics, HKUST, Hong Kong, P.R.China

International Journal of Theoretical and Applied Finance (IJTAF), 2001, vol. 04, issue 06, 921-938

Abstract: Credit contagion means that the credit deterioration of an entity causes the credit deterioration of other entities. In this paper, we build and test a continuous-time model for defaultable securities using a diffusive process for risk-free interest rate, and a finite-state continuous-time Markov process for the correlation of credit. The credit contagion, in particular, is established by relating transition rates of various credit states. Examples of derivative pricing with calibrated credit contagion model are provided. Initial empirical results with the benchmarks of Brady bonds show that our model is a viable new technique for the pricing and risk-managing of credit derivatives.

Keywords: Non-option instruments; Markov process; credit contagion model (search for similar items in EconPapers)
Date: 2001
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DOI: 10.1142/S0219024901001309

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