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A Model for Dependent Defaults and Pricing Contingent Claims with Counterparty Risk

by Dariusz Gatarek of Unicredit, and
Juliusz Jabłecki of National Bank of Poland

April 2013

Abstract: This paper presents a new, intuitive but mathematically powerful model of dependent defaults and derives a general framework for pricing products whose values depend on credit correlation between the counterparty and the reference entity. The dependence framework is a natural extension of the Gaussian factor approach, which can be applied in the context of reduced form credit risk models, allowing i.a. for stochastic hazard and recovery rates. The prices of plain vanilla credit default swaps, first-to-default swaps and default swaptions are derived as particular examples.

JEL Classification: G12, G13.

AMS Classification: 91B28, 91B70.

Keywords: default correlation, counterparty risk, reduced form models.

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