Modelling Bonds & Credit Default Swaps using a Structural Model with Contagion

TL;DR

This paper introduces a two-dimensional structural model that captures default contagion and correlation effects to value credit default swaps and corporate bonds, producing realistic credit spread term structures.

Contribution

It presents a novel two-dimensional framework incorporating contagion and correlation for pricing credit derivatives and bonds, with analytical formulas derived for spreads and yields.

Findings

Model generates diverse credit spread term structures.

Incorporates both correlation and contagion effects.

Provides analytical formulas for spreads and yields.

Abstract

This paper develops a two-dimensional structural framework for valuing credit default swaps and corporate bonds in the presence of default contagion. Modelling the values of related firms as correlated geometric Brownian motions with exponential default barriers, analytical formulae are obtained for both credit default swap spreads and corporate bond yields. The credit dependence structure is influenced by both a longer-term correlation structure as well as by the possibility of default contagion. In this way, the model is able to generate a diverse range of shapes for the term structure of credit spreads using realistic values for input parameters.