Correlated Default with Incomplete Information
by Kay Giesecke of Cornell University
Abstract: The recent accounting scandals at Enron, WorldCom, and Tyco were related to the misrepresentation of liabilities. We provide a structural model of correlated multi-firm default, in which public bond investors are uncertain about the liability-dependent barrier at which individual firms default. In lack of complete information, investors form prior beliefs on the barriers, which they update with the default status information of firms arriving over time. Whenever a firm suddenly defaults, investors learn about the default threshold of closely associated business partner firms. Due to the unpredictable nature of defaults in our model, this updating leads to "contagious" jumps in credit spreads of business partner firms, which correspond to re-assessments of these firms' health by investors. We characterize joint default probabilities and the default dependence structure as assessed by imperfectly informed investors, where we emphasize the the modeling of dependence with copulas. A case study based on Brownian asset dynamics illustrates our results.
Published in: Journal of Banking & Finance, Vol. 28, No. 7, (July 2004), pp. 1521-1545.