Semi-Analytical Valuation of Basket Credit Derivatives in Intensity-Based Models

by Allan Mortensen of Goldman Sachs International

January 13, 2006

Abstract: This paper presents a semi-analytical valuation method for basket credit derivatives in a flexible intensity-based model. Default intensities are modeled as correlated affine jump-diffusions. An empirical application documents that the model fits market prices of benchmark basket credit derivatives reasonably well, consistent with the observed correlation skew. Hence, I argue, contrary to comments in the literature, that intensity-based portfolio credit risk models can be both tractable and capable of generating realistic levels of default correlation.

JEL Classification: G13.

Keywords: credit derivatives, CDOs, default correlation, intensity-based, models, affine jump-diffusions.

Published in: Journal of Derivatives, Vol. 13, No. 4, (Summer 2006), pp. 8-26.

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