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Correlated Defaults and the Valuation of Defaultable Securities

by Fan Yu of the University of California, Irvine

April 1, 2004

Abstract: We present an intensity-based model of correlated defaults with application to the valuation of defaultable securities. The model assumes that the conditional hazard rate of default is driven by external common factors as well as other defaults in the system. A proposed recursive procedure can be used to generate default times with a broad class of correlation structures. We compare this approach to standard reduced-form models based on conditional independence, as well as recent innovations involving copula functions. We also illustrate its use with examples on the pricing of defaultable bonds, and credit default swaps of the regular and basket type.

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