On Correlation and Default Clustering in Credit Markets
by Antje Berndt of Carnegie Mellon University,
October 25, 2009
Abstract: We establish Markovian models in the Heath, Jarrow and Morton paradigm that permit an exponential affine representation of riskless and risky bond prices while offering significant flexibility in the choice of volatility structures. Estimating models in our family is typically no more difficult than estimating term structure models in the workhorse affine family. In addition to diffusive and jump-induced default correlations, default events can impact credit spreads of surviving firms. This feature allows a greater clustering of defaults. Numerical implementations highlight the importance of taking interest rate-credit spread correlations, credit spread impact factors and the full credit spread curve information into account when building a unified model framework that prices any credit derivative.
Keywords: Markovian HJM Models, Credit Derivatives, Default Clustering, Counterparty Credit Risk.
Published in: Review of Financial Studies, Vol. 23, No. 7, (July 2010), pp. 2680-2729.