A Model for Counterparty Risk with Geometric Attenuation Effect and the Valuation of CDS

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A Model for Counterparty Risk with Geometric Attenuation Effect and the Valuation of CDS

by Yunfen Bai of Shanghai Jiaotong University & Shijiazhuang College,
Xinhua Hu of Shanghai Jiaotong University, and
Zhongxing Ye of Shanghai Jiaotong University

January 2007

Abstract: In this paper, a geometric function is introduced to reflect the attenuation speed of impact of one firm's default to its partner. If two firms are competitions (copartners), the default intensity of one firm will decrease (increase) abruptly when the other firm defaults. As time goes on, the impact will decrease gradually until extinct. In this model, the joint distribution and marginal distributions of default times are derived by employing the change of measure, so can we value the fair swap premium of a CDS.

AMS Classification: 62P05.

Keywords: Dependent default, Geometric attenuation function, Change of measure, Credit Default Swap(CDS).

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