Journal of Credit Risk

Risk.net

Credit and basket default swaps

Dilip B. Madan, Michael Konikov, Mircea Marinescu

ABSTRACT

We evaluate extreme value distribution models for the time to default distribution embedded in market credit default swap quotes. Two distribution classes, the Weibull and Frechet, are considered and it is observed that though both are adequate, the Weibull model has a better fit to the data. We also provide details for the pricing of N th to default contracts using the one-factor Gaussian and the Clayton copulas. An illustration of the first, second and third to default contracts on a basket of six firms in the financial sector is conducted. Gaussian first to default prices are seen to be closer to the independence boundary relative to the Clayton copula prices. The Weibull is shown to possibly also be adequate for the distribution of the first, second and third to default times.