Bankruptcy, Counterparty Risk, and Contagion

65 Pages Posted: 16 May 2006

See all articles by Holger Kraft

Holger Kraft

Goethe University Frankfurt

Mogens Steffensen

University of Copenhagen

Date Written: May 5, 2006

Abstract

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. Other applications include the modeling of a more sophisticated default process of a firm. 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 risky 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 risky claims explicitly and efficiently.

Keywords: default risk, financial distress, default correlation, contagion, Markov chain

JEL Classification: G13

Suggested Citation

Kraft, Holger and Steffensen, Mogens, Bankruptcy, Counterparty Risk, and Contagion (May 5, 2006). Available at SSRN: https://ssrn.com/abstract=901270 or http://dx.doi.org/10.2139/ssrn.901270

Holger Kraft (Contact Author)

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Mogens Steffensen

University of Copenhagen ( email )

Universitetsparken 5
DK-2100 Copenhagen
Denmark

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