VALUING CREDIT DEFAULT SWAPS II: MODELING DEFAULT CORRELATIONS

Abstract

This paper extends the analysis in Valuing Credit Default Swaps I: No Counter party Default Risk to provide a methodology for valuing credit default swaps that takes account of counterparty default risk and allows the payoff to be contingent on defaults by multiple reference entities. It develops a model of default correlations between different corporate or sovereign entities. The model is applied to the valuation of vanilla credit default swaps when the seller may default and to the valuation of basket credit default swaps.