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The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling

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  • Xiao, Tim

Abstract

This article presents a comprehensive framework for valuing financial instruments subject to credit risk and collateralization. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats to financial markets. Some well-known risky valuation models in the markets can be viewed as special cases of this framework. We introduce the concept of comvariance (or comrelation) into the area of credit risk modeling to capture the default relationship among three or more parties. Accounting for default correlations and comrelations becomes important, especially during the credit crisis. Moreover, we find that collateralization works well for financial instruments subject to bilateral credit risk, but fails for ones subject to multilateral credit risk.

Suggested Citation

  • Xiao, Tim, 2013. "The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling," MPRA Paper 47136, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:47136
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    References listed on IDEAS

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    Cited by:

    1. Xiao, Tim, 2013. "An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk," MPRA Paper 47104, University Library of Munich, Germany.
    2. Tim Xiao, 2015. "Is the jump-diffusion model a good solution for credit risk modelling? The case of convertible bonds," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 4(1), pages 1-25.

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    More about this item

    Keywords

    asset pricing; credit risk modeling; unilateral; bilateral; multilateral credit risk; collateralization; comvariance; comrelation; correlation.;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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