Modeling of contagion effects and their influence to the pricing and hedging of basket credit derivatives

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The financial health of a firm is influenced by fluctuating macroeconomic factors, such as economic growth changes. This dependence between defaults can be modeled using standard reduced-form credit risk models with conditionally independent defaults. Credit contagion refers to the spread of financial distress from one entity to another, challenging the classical assumption that default probabilities rely solely on common factors. Existing contagion models can be categorized into types, with Jarrow & Yu's counterparty risk model and Schönbucher's frailty model as key representatives. Additionally, two original models are proposed: a correlated firm value model based on Credit Metric’s framework and a correlated firm value with jump model. In the correlated firm value model, asset values depend on both common and firm-specific factors, with tied firms defined as business partners within economic networks. This creates a factor model where asset values are interconnected. The correlated firm value with jump model introduces influence factors into a jump process. The study examines pricing effects from these contagion models, particularly for second-to-default basket credit derivatives and CDO prices, revealing differing pricing trends. Finally, the author suggests hedging strategies in the context of contagion.