COUNTERPARTY RISK FOR CREDIT DEFAULT SWAP WITH STATES RELATED DEFAULT INTENSITY PROCESSES

Dan Tang (), Yongjin Wang () and Yuzhen Zhou ()
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Dan Tang: School of International Trade and Economics, University of International Business and Economics, Beijing, 100029, China
Yongjin Wang: School of Business and School of Mathematical Sciences, Nankai University, Tianjin, 300071, China
Yuzhen Zhou: Department of Statistics and Probability, Michigan State University, East Lansing MI, 48824, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2011, vol. 14, issue 08, 1335-1353

Abstract: In this paper, the counterparty risk is considered in pricing a Credit Default Swap (abbr. CDS). We adopt an intensity-based reduced form model, in which the default intensity processes of the counterpart and the reference credit are modulated by the credit states of the firms. Two Markov chains are used to describe the credit state processes. We set up a model where the default correlation between the counterpart and the reference is described through the Markov chains. A semi-explicit formula for the pricing of CDS with counterparty risk is obtained. We analyze the impacts of default correlations and the state changes on the CDS price through some numerical experiments.

Keywords: Credit default swap; counterparty risk; Markov modulated processes (search for similar items in EconPapers)
Date: 2011
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DOI: 10.1142/S0219024911006863

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