Essays on default risk

Abstract

This thesis deals with three subjects. The first develops a structural model for default correlations that is capable of dealing with temporal and cross-sectional differences. The Merton``s (1974) model and the first-passage-time model of Zhou (2001) are extended to incorporate systematic risk factors in the asset value dynamics. Using the extended models, I analyze the relationship between default probabilities, default correlations, credit grades, and business cycle fluctuations. Extensions provide an easily implementable approach to default probabilities and default correlations that uses both firm-specific and macroeconomic information and allow theoretical justification for recent empirical findings. I also demonstrate a few potential uses of the model, including pricing credit derivatives subject to market risk and multiple defaults, and managing credit portfolio risk. The second suggests a methodology for valuing credit default swaps that takes account of counterparty default risk as well as correlated market and credit risk. It incorporates market risk into determining default correlations between multiple firms using the first-passage-time approach. The model is applied to the valuation of vanilla credit default swaps with counterparty default risk and to the valuation of basket credit default swaps. The pricing error in credit default swaps can be substantial by ignoring the correlation between market risk and credit risk, as well as between counterparty credit risk and reference credit risk. The market risk as well as the correlation between market and credit risk has a varying degree of impact on default swap rates depending on swap maturity and the credit quality of the parties involved. In addition, because the sensitivity of basket credit default swap rates to market risk increases with the number of reference entities, the valuation error can be more substantial in pricing basket credit default swaps than credit default swaps with a single refer...