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Recursive Valuation of Basket Default Swaps

by Ian Iscoe of Algorithmics, Inc., and
Alex Kreinin of Algorithmics, Inc.

Spring 2006

Abstract: In this paper we consider an analytical valuation of Basket Default Swaps. Our solution is based on a continuous-time model in a conditional independence framework. We use the order statistics of the default times of the names in the basket to find a recursive algorithm for computation of the risk-neutral distribution of the default process of the basket. We derive an analytical expression for the value of the first-to-default swap, which leads to a solution for an m th -to-default swap, using the recursive algorithm. The accuracy and performance of the analytical method are compared with that obtained using Monte Carlo simulation.

Published in: Journal of Computational Finance, Vol. 9, No. 3, (Spring 2006), pp. 95-116.

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