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Credit Contagion: Pricing Cross-Country Risk In Brady Debt Markets

Author

Listed:
  • MARCO AVELLANEDA

    (Department of Mathematics, Courant Institute, New York University, NY 10012, USA)

  • LIXIN WU

    (Department of Mathematics, HKUST, Hong Kong, P.R.China)

Abstract

Credit contagion means that the credit deterioration of an entity causes the credit deterioration of other entities. In this paper, we build and test a continuous-time model for defaultable securities using a diffusive process for risk-free interest rate, and a finite-state continuous-time Markov process for the correlation of credit. The credit contagion, in particular, is established by relating transition rates of various credit states. Examples of derivative pricing with calibrated credit contagion model are provided. Initial empirical results with the benchmarks of Brady bonds show that our model is a viable new technique for the pricing and risk-managing of credit derivatives.

Suggested Citation

  • Marco Avellaneda & Lixin Wu, 2001. "Credit Contagion: Pricing Cross-Country Risk In Brady Debt Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 4(06), pages 921-938.
    • Handle: RePEc:wsi:ijtafx:v:04:y:2001:i:06:n:s0219024901001309
    DOI: 10.1142/S0219024901001309
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    Citations

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    Cited by:

    1. Dianfa Chen & Jun Deng & Jianfen Feng & Bin Zou, 2017. "An Explicit Default Contagion Model and Its Application to Credit Derivatives Pricing," Papers 1706.06285, arXiv.org, revised Aug 2018.
    2. Alfonso Mendoza, 2004. "Modelling long memory and risk premia in Latin American sovereign bond markets," Money Macro and Finance (MMF) Research Group Conference 2003 65, Money Macro and Finance Research Group, revised 13 Oct 2004.
    3. Herbertsson, Alexander, 2007. "Modelling Default Contagion Using Multivariate Phase-Type Distributions," Working Papers in Economics 271, University of Gothenburg, Department of Economics.
    4. Rama Cont, 2023. "In memoriam: Marco Avellaneda (1955–2022)," Mathematical Finance, Wiley Blackwell, vol. 33(1), pages 3-15, January.
    5. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
    6. Yi-Hsuan Chen & Kehluh Wang & Anthony Tu, 2011. "Default correlation at the sovereign level: evidence from some Latin American markets," Applied Economics, Taylor & Francis Journals, vol. 43(11), pages 1399-1411.
    7. Herbertsson, Alexander & Rootzén, Holger, 2007. "Pricing k-th-to-default Swaps under Default Contagion: The Matrix-Analytic Approach," Working Papers in Economics 269, University of Gothenburg, Department of Economics.
    8. Herbertsson, Alexander, 2007. "Pricing Synthetic CDO Tranches in a Model with Default Contagion Using the Matrix-Analytic Approach," Working Papers in Economics 270, University of Gothenburg, Department of Economics.
    9. Alexander Herbertsson, 2011. "Modelling default contagion using multivariate phase-type distributions," Review of Derivatives Research, Springer, vol. 14(1), pages 1-36, April.

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