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Counterparty Risk For Credit Default Swap With States Related Default Intensity Processes

Author

Listed:
  • DAN TANG

    (School of International Trade and Economics, University of International Business and Economics, Beijing, 100029, China)

  • YONGJIN WANG

    (School of Business and School of Mathematical Sciences, Nankai University, Tianjin, 300071, China)

  • YUZHEN ZHOU

    (Department of Statistics and Probability, Michigan State University, East Lansing MI, 48824, USA)

Abstract

In this paper, the counterparty risk is considered in pricing a Credit Default Swap (abbr. CDS). We adopt an intensity-based reduced form model, in which the default intensity processes of the counterpart and the reference credit are modulated by the credit states of the firms. Two Markov chains are used to describe the credit state processes. We set up a model where the default correlation between the counterpart and the reference is described through the Markov chains. A semi-explicit formula for the pricing of CDS with counterparty risk is obtained. We analyze the impacts of default correlations and the state changes on the CDS price through some numerical experiments.

Suggested Citation

  • Dan Tang & Yongjin Wang & Yuzhen Zhou, 2011. "Counterparty Risk For Credit Default Swap With States Related Default Intensity Processes," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 14(08), pages 1335-1353.
    • Handle: RePEc:wsi:ijtafx:v:14:y:2011:i:08:n:s0219024911006863
    DOI: 10.1142/S0219024911006863
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