Valuing Default Swaps Under Market and Credit Risk Correlation

US corporate default swap valuation: the market liquidity hypothesis and autonomous credit risk

“…When l t = 0 the three-factor model collapses to the Jarrow et al's (2001) two-factor framework. The model assumes that markets are frictionless, arbitrage free and characterized by a constant exogenous recovery rate (r t ).…”

“…The study will begin by laying out the proposed model structure and components of the model following the two-factor model developed by Jarrow et al (2001). In the initial specification of the model the hazard rate is only a function of the default-free interest rate.…”

“…This section lays out the model structure and the component parts of the model following the two-factor reduced form approach developed by Jarrow et al (2001).…”

“…Additionally, Jarrow et al (2001) further suggests that an increase in market risk increases the likelihood of the issuing firm defaulting on its debt obligation. This study further postulates that liquidity decreases with a deterioration of credit quality, hence we would expect that low investment grade and high yield grade securities would have less liquid markets than high investment grade instruments.…”

Valuation of Credit Default Swap with Counterparty Default Risk by Structural Model

“…Technically it is difficult because correlation between the entities involved in the contract is hard to deal with. Jarrow and Yildirim [12] obtained a closed form valuation formula for a CDS based on reduced form approach with correlated credit risk. In their model, the default intensity is assumed to be linear in the short interest rate.…”