The double default value-of-the-firm model

ABSTRACT In the new Basel Accord, banks have the possibility to consider the double default;effect of a guaranteed exposure, which is when both the obligor and the guarantor fail;to meet their obligations. This question is currently taken into account by a multivariate;value-of-the-firm model, with increased asset correlations between the obligor and;the guarantor, in order to capture the additional link created by the guarantee. Such;an approach is misleading, since the obligor and guarantor are treated in a symmetric;way, whereas the link between obligor and guarantor is clearly asymmetric. Moreover,;their joint default involves an over-the-counter price of the guarantee, whose existence;and uniqueness have to be analyzed. The aim of our paper is to specify this link in;detail, to discuss how it depends on the type of guarantee and the seniorities of the;components of the debts, and to deduce its implications in terms of risk management.