Valuing Credit Default Swaps Ii: Modeling Default Correlations

This paper extends the analysis in Valuing Credit Default Swaps I: No Counter-party Default Risk to provide a methodology for valuing credit default swaps that takes account of counterparty default risk and allows the payoff to be contingent on defaults by multiple reference entities. It develops a model of default correlations between different corporate or sovereign entities. The model is applied to the valuation of vanilla credit default swaps when the seller may default and to the valuation of basket credit default swaps. 2 In Hull and White (2000) we explained how a vanilla credit default swap (CDS) can be valued when there is no counterparty default risk. This is a two stage procedure. The first stage is to calculate the risk-neutral probability of default at future times from the yields on bonds issued by the reference entity (or by corporations considered to have the same risk of default as the reference entity). The second stage is to calculate the present value of both the expected future payoff and expected future payments on the credit default