CORRELATED DEFAULTS IN INTENSITY‐BASED MODELS

Fan Yu

Mathematical Finance, 2007, vol. 17, issue 2, 155-173

Abstract: This paper presents an intensity‐based model of correlated defaults with application to the valuation of defaultable securities. The model assumes that the intensities of the default times are driven by common factors as well as other defaults in the system. A recursive procedure called the “total hazard construction” is used to generate default times with a broad class of correlation structures. This approach is compared to standard reduced‐form models based on conditional independence as well as alternative approaches involving copula functions. Examples are given for the pricing of defaultable bonds and credit default swaps of the regular and basket type.

Date: 2007
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