Review of Finance Advance Access published online on March 13, 2007
Review of Finance, doi:10.1093/rof/rfm002
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Bankruptcy, Counterparty Risk, and Contagion*
1 University of Kaiserslautern
2 University of Copenhagen
This paper provides a unifying framework for the modeling of various types of credit risks such as contagion effects. We argue that Markov chains can efficiently be used to tackle these problems. However, our approach is not limited to pricing problems with contagion. On the theoretical side, we derive pricing formulas for three building blocks that are generalizations of contingent claims studied in Lando (1998). These claims can be thought of as atoms forming the basis for all credit risk payments. Furthermore, we demonstrate that, in general, all contingent claims exposed to credit risk satisfy a system of partial differential equations. This is the key result to calculate prices of credit risk claims explicitly and efficiently.
JEL Classification: G13, G33
* This paper has been finished while Holger Kraft was visiting the Anderson School at UCLA. We thank Franklin Allen, Francis Longstaff, and an anonymous referee for valuable comments and suggestions. All remaining errors are of course our own. Holger Kraft gratefully acknowledges financial support by Deutsche Forschungsgemeinschaft (DFG).