Counterparty Risk and the Pricing of Defaultable Securities
Abstract: Motivated by recent financial crises in East Asia and the United States where the downfall of a small number of firms had an economy-wide impact, this paper generalizes existing reduced-form models to include default intensities dependent on the default of a counterparty. In this model, firms have correlated defaults due to not only an exposure to common risk factors, but also to firm-specific risks that are termed "counterparty risks." Numerical examples illustrate the effect of counterparty risk on the pricing of defaultable bonds and credit derivatives such as default swaps.
Published in: Journal of Finance, Vol. 56, No. 5, (October 2001), pp. 1765-1799.