M. Hamp (Canada), J. Kettunen, and G. Meissner (USA)
Default swap pricing, copula, reference asset – counterparty default correlation, Libor Market Model (LMM) JEL Classification: G12, G13
The paper derives a model with a closed form solution for valuing credit default swaps including reference asset – counterparty default correlation. The default correlation between the reference asset and the counterparty is incorporated in two quadruple trees. One tree represents the default swap payoff of the default swap seller; the other tree represents the default swap premium payments of the default swap buyer. Swap valuation techniques are then applied to derive the fair default swap price. The model incorporates two correlation approaches used in today’s credit practice, the Gaussian copula approach and the binomial correlation approach. The Gaussian copula results in higher and non-linear credit default swap spreads with respect to correlation compared to the binomial approach. The model is represented with three LMM (Libor Market Model) processes. One LMM process simulates risk-free short-term interest rates. Two more LMM processes generate the reference asset default probabilities and the counterparty default probabilities. A Visual Basic open source code version of the model is provided.
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