EFFECT OF ASSET VALUE CORRELATION ON CREDIT-LINKED NOTE VALUES

C. H. Hui () and C. F. Lo
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C. H. Hui: Banking Policy Department, Hong Kong Monetary Authority, 30th Floor, 3, Garden Road, Hong Kong
C. F. Lo: Physics Department, The Chinese University of Hong Kong, Shatin, Hong Kong

International Journal of Theoretical and Applied Finance (IJTAF), 2002, vol. 05, issue 05, 455-478

Abstract: This paper develops a simple model to study the credit risk premiums of credit-linked notes using the structural model. Closed-form solutions of credit risk premiums of the credit-linked notes derived from the model as functions of firm values and the short-term interest rate, with time-dependent model parameters governing the dynamics of the firm values and interest rate. The numerical results show that the credit spreads of a credit-linked note increase non-linearly with the decrease in the correlation between the asset values of the note issuer and the reference obligor when the final payoff condition depends on the asset values of the note issuer and the reference obligor. When the final payoff condition depends on the recovery rate of the note issuer upon default, the credit spreads could increase with the correlation. In addition, the term structures of model parameters and the correlations involving interest rate are clearly the important factors in determining the credit spreads of the notes.

Keywords: Credit risk; risky bonds; contingent claim analysis (search for similar items in EconPapers)
Date: 2002
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024902001535

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