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An Explicit, Multi-Factor Credit Default Swap Pricing Model with Correlated Factors

by Ren-Raw Chen of Rutgers University,
Xiaolin Cheng of Rutgers University,
Frank J. Fabozzi of Yale University, and
Bo Liu of Fitch Ratings

July 27, 2006

Abstract: With the recent significant growth in the single-name credit default swap market has come the need for accurate and computationally efficient models to value these instruments. While the model developed by Duffie-Pan-Singleton (2000) model can be used, the solution is numerical (solving a series of ordinary differential equations) rather than explicit. In this paper, we provide an explicit solution to the valuation of a credit default swap when the interest rate and the hazard rate are correlated by using the "change of measure" approach and solving a bivariate Riccati equation. CDS transaction data for the period 2/15/2000 through 4/8/2003 for 60 firms are used to both test the goodness of fit of the model and provide estimates of the influence of economic variables in the market for credit risky bonds.

Keywords: CDS.

Published in: Journal of Financial and Quantitative Analysis, Vol. 43, No. 1, (March 2008), pp. 123-160.

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