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Counterparty Risk and the Pricing of Defaultable Securities

In: Financial Derivatives Pricing Selected Works of Robert Jarrow

Author

Listed:
  • ROBERT A. JARROW

    (Johnson Graduate School of Management, Cornell University, USA)

  • FAN YU

    (Graduate School of Management, University of California at Irvine, USA)

Abstract

Motivated by recent financial crises in East Asia and the United States where the downfall of a small number of firms had an economy-wide impact, this paper generalizes existing reduced-form models to include default intensities dependent on the default of a counterparty. In this model, firms have correlated defaults due not only to an exposure to common risk factors, but also to firm-specific risks that are termed "counterparty risks." Numerical examples illustrate the effect of counterparty risk on the pricing of defaultable bonds and credit derivatives such as default swaps.

Suggested Citation

  • Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789812819222_0020
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    Keywords

    Derivatives; Options; Hedging; HJM; Black–Scholes; Forwards; Futures; Martingale Measure; Calls; Puts; Market Manipulation; Margin Requirements;
    All these keywords.

    JEL classification:

    • B26 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Financial Economics
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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