A Spread-Based Model for the Valuation of Credit Derivatives with Correlated Defaults and Counter-Party Risks

Abstract

We set out, in this paper, to extend the Das and Sundaram (2000) model as a means of simultaneously considering correlated default risk structure and counter-party risk. The multinomial model established by Kamrad and Ritchken (1991) is subsequently modified in order to facilitate the development of a computational algorithm for valuing two types of active credit derivatives, credit-spread options and default baskets. From our numerical examples, we find that along with the correlated default risk, the existence of counter-party risk results in a substantially lower valuation of credit derivatives. In addition, we find that different settings of the term structure of interest rate volatility also have a significant impact on the value of credit derivatives.

Citation

Chang, C.-C. and Jih-Chieh, Y. (2006), "A Spread-Based Model for the Valuation of Credit Derivatives with Correlated Defaults and Counter-Party Risks", Chen, A.H. (Ed.) Research in Finance (Research in Finance, Vol. 23), Emerald Group Publishing Limited, Leeds, pp. 193-220. https://doi.org/10.1016/S0196-3821(06)23007-7