Journal of Credit Risk

Risk.net

Modeling joint defaults in correlation-sensitive instruments

Juliusz Jabłecki and Dariusz Gątarek

  • A simple model for joint defaults is presented.
  • The authors show how it can be applied to pricing and risk-managing instruments which are sensitive to credit correlation.
  • The model is straightforward to calibrate and produces very good fit for market prices of EFSF bonds and iTraxx tranches.

ABSTRACT

This paper presents a simple model for joint defaults and shows how it can be applied to pricing and risk-managing instruments that are sensitive to credit correlation, from simple repos to collateralized debt obligations. The model relies on a conservative and intuitive representation of a systematic factor as a chain of dependencies running through the whole economy. This allows capturing the concentration of defaults in time and endogenously produces dynamics of default correlation as the model output rather than its input.

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