the web's biggest credit risk modeling resource.

Credit Jobs

Home Glossary Links FAQ / About Site Guide Search


Submit Your Paper

In Rememberance: World Trade Center (WTC)

Export citation to:
- Text (plain)
- BibTeX

Correlated Default Modeling with a Forest of Binomial Trees

by Santhosh Bandreddi of Merrill Lynch,
Sanjiv Das of Santa Clara University, and
Rong Fan of Gifford Fong Associates

October 29, 2007

Abstract: This paper exploits the endogenous default function framework of Das and Sundaram (2007) to develop an approach for modeling correlated default on binomial trees usually used for pricing equity options. We show how joint default contracts may be valued on these trees. The model accommodates different correlation assumptions and practical implementation considerations. Credit portfolio characteristics are examined within the model and found to be consistent with stylized empirics. Risk premia for default are computable and shown to be relatively higher for poor quality firms. Equity volatility is shown to impact correlated credit loss distributions substantially. Two kinds of default dependence are explored, one coming from default intensity correlations, and the other from further conditional dependence in defaults after accounting for intensity correlations (residual copula correlation). Both are found to impact credit loss distributions, though the absence of either makes these distributions less sensitive to correlation assumptions; on balance intensity correlations are more critical.

Published in: Journal of Fixed Income, Vol. 17, No. 3, (Winter 2007), pp. 38-56.

Download paper (251K PDF) 30 pages