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Modeling Default Dependence with Threshold Models

by Ludger Overbeck of Deutsche Bank AG, and
Wolfgang Schmidt of Hochschule für Bankwirtschaft

March 18, 2003

Abstract: We investigate the problem of modeling defaults of dependent credits. In the framework of the class of structural default models we study threshold models where for each credit the underling ability-to-pay process is a transformation of a Wiener processes. We propose a model for dependent defaults based on correlated Wiener processes whose time scales are suitably transformed in order to calibrate the model to given marginal default distributions for each underlying credit. At the same time the model allows for a straightforward analytic calibration to dependency information in the form of joint default probabilities.

JEL Classification: G12, G13, G24, C69.

Keywords: credit default, credit derivative, default dependence, structural form models, threshold model.

Published in: Journal of Derivatives, Vol. 12, No. 4, (Summer 2005), pp. 10-19.

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