Modeling basket credit default swaps with default contagion

Helen Haworth and Christoph Reisinger

Journal of Credit Risk

Abstract: ABSTRACT The specification of a realistic dependence structure is key to the pricing of multi-name credit derivatives. We value small kth-to-default credit default swap baskets in the presence of asset correlation and default contagion. Using a first-passage framework, firm values are modeled as correlated geometric Brownian motions with exponential default thresholds. Idiosyncratic links between companies are incorporated through a contagion mechanism whereby a default event leads to jumps in volatility at related entities. Our framework allows for default causality and is extremely flexible, enabling us to evaluate the spread impact of firm value correlations and credit contagion for symmetric and asymmetric baskets.

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