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Modeling Correlated Defaults: First passage model under stochastic volatility

by Jean-Pierre Fouque of the University of California at Santa Barbara,
Brian Wignall of the University of California at Santa Barbara, and
Xianwen Zhou of Lehman Brothers

November 6, 2007

Abstract: Default dependency structure is crucial in pricing multi-name credit derivatives as well as in credit risk management. In this paper, we extend the first passage model for one name with stochastic volatility (Fouque-Sircar-Sølna, Applied Mathematical Finance 2006) to the multi-name case. Correlation of defaults is generated by correlation between the Brownian motions driving the individual names as well as through common stochastic volatility factors. A numerical example for the loss distribution of a portfolio of defaultable bonds is examined after stochastic volatility is incorporated.

Published in: Journal of Computational Finance, Vol. 11, No. 3, (Spring 2008), pp. 43-78.

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