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A Multiname First-Passage Model for Credit Risk

by Don L. McLeish of the University of Waterloo, and
Adam Metzler of the University of Western Ontario

July 23, 2009

Abstract: In multiname extensions of the seminal Black-Cox model, dependence is typically introduced by correlating the Brownian motions driving firm values. Despite its significant intuitive appeal such a framework is simply not capable of describing market data. In this paper we propose a novel multiname framework by altering the location of systematic risk in the Black-Cox model. This is accomplished by introducing common "systematic risk" processes which govern the trend and volatility in credit qualities. We are able to calibrate several versions of the model to market quotes for CDX index tranches, including quotes from the current distressed environment.

Keywords: credit risk, first passage models, conditional independence, CDOs.

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