Sequential Defaults and Incomplete Information

by Kay Giesecke of Cornell University, and
Lisa R. Goldberg of MSCI Barra, Inc.

Fall 2004

Abstract: We propose a multi-firm first-passage credit model in which investors have incomplete information. In this model, investors observe neither a firm's value nor its default barrier. The model takes into account the short-term risk inherent in default events, the market-wide impact of defaults on security prices due to counterparty relations among firms, and the cyclical default dependence effects observed in credit markets. We explicitly calculate the pricing trend and the arrival intensity of the kth-to-default. These results furnish (1) tractable reduced form formulae for arrival probabilities of sequential dependent defaults and prices of multi-name credit derivatives, and (2) an algorithm for the simulation of sequential unpredictable default times.

Published in: Journal of Risk, Vol. 7, No. 1, (Fall 2004), pp. 1-26.

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