A local volatility model is enhanced by the possibility of a single jump to default. The jump has a hazard rate that is the product of the stock price raised to a prespecified negative power and a deterministic function of time. The empirical work uses a power of −1.5. It is shown how one may simultaneously recover from the prices of credit default swap contracts and equity option prices both t...

The way monoline insurers estimate the FAS 157 credit value adjustments (CVA) on their ABS CDO insurance portfolios vastly overstates the benefits. We propose a simple method that is more accurate, especially when the counterparty default risk is high. The counterparty default recovery rate is also a critical input. Counterparty credit risk is an important topic today with credit crunch affecti...

In this paper, under the reduced form framework and “Bottom Up” method, a model for pricing a basket Loan-only Credit Default Swap (LCDS), with the negative correlation between prepayment and default, is established. A general pricing formula for it is obtained, where one factor CIR (Cox-Ingersoll-Ross) and ICIR (Inversed CIR) models are used to describe the negative correlation between prepaym...

We examine the effect of introducing credit default swaps (CDSs) on firms’ investment and financing policies. Our model allows for dynamic investment and dynamic financing using equity and debt, and debt holders can trade in the CDS market. After calibrating the model, we compare an economy with a CDS market to an economy without one. The model contains both positive and negative effects of CDS...

Characterizing the dependence in credit spreads and default intensities across companies is a central problem in credit risk. Existing practice typically relies on factor models or simple static Gaussian copula models. We instead use genuinely dynamic copula models which can capture univariate and multivariate non-normalities and asymmetries for large cross-sections of firms. Using weekly data ...

In this paper, we present two efficient algorithms for pricing credit default swaps based on a structural default model. In our model, the value of the firm is assumed to be the exponential of a jump-diffusion process. Our first algorithm to price a credit default swap within this framework is an efficient and unbiased Monte Carlo simulation. An excellent performance is obtained by first simula...