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Interacting Defaults and Counterparty Risk: a Markovian Approach

by Rüdiger Frey of the University of Leipzig, and
Jochen Backhaus of the University of Leipzig

July 2003

Abstract: We consider intensity-based dynamic models for dependent defaults. We generalize the standard reduced-form models and assume that the default intensity of a firm is directly affected by the default of other firms in the portfolio. This interaction between defaults, which is termed counterparty risk in the literature, could be due to direct business relations between firms or due to the impact of defaults on the overall credit climate. We construct and study the model using Markov process techniques. We study in detail a model where the interaction between firms is of mean-field type.

Keywords: Credit risk, dependent defaults, Markov processes, mean-field model.

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