Modeling correlated defaults: first passage model under stochastic volatility

Jean-Pierre Fouque, Brian C. Wignall, Xianwen Zhou

Abstract

ABSTRACT

Default dependency structure is crucial in pricing multi-name credit derivatives as well as in credit risk management. In this paper, we extend the first passage model for one name with stochastic volatility (Fouque et al 2006) to the multi-name case. Correlation of defaults is generated by correlation between the Brownian motions driving the individual names as well as through common stochastic volatility factors. A numerical example for the loss distribution of a portfolio of defaultable bonds is examined after stochastic volatility is incorporated.