Pricing and Hedging of Portfolio Credit Derivatives with Interacting Default Intensities

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

September 29, 2008

Abstract: We consider reduced-form models for portfolio credit risk with interacting default intensities. In this class of models default intensities are modelled as functions of time and of the default state of the entire portfolio, so that phenomena such as default contagion or counterparty risk can be modelled explicitly. In the present paper this class of models is analyzed by Markov process techniques. We study in detail the pricing and the hedging of portfolio-related credit derivatives such as basket default swaps and collaterized debt obligations (CDOs) and discuss the calibration to market data.

JEL Classification: G31, G11, C15.

Keywords: Credit derivatives, CDOs, Hedging, Markov chains.

Published in: International Journal of Theoretical and Applied Finance, Vol. 11, No. 6, (September 2008), pp. 611-634.

Previously titled: Credit Derivatives in Models with Interacting Default Intensities: a Markovian Approach --and before that-- Portfolio Credit Risk Models with Interacting Default Intensities: a Markovian Approach

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