Counterparty Risk and the Pricing of Defaultable Securities

Authors

  • Robert A. Jarrow,

  • Fan Yu

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    • Jarrow is from the Johnson Graduate School of Management, Cornell University, and Ka-makura Corporation, and Yu is from the Graduate School of Management, University of California at Irvine. A previous version of this paper appeared as Chapter 1 of Yu's doctoral dissertation at Cornell University. We thank Warren Bailey, Richard Green (the editor), Haitao Li, Robert Masson, George Oldfield, George Pennacchi, an anonymous referee, and seminar participants at Baruch College, Boston University, the College of William and Mary, Cornell University, the Federal Reserve Bank of New York, Georgetown University, McGill University, Rice University, the University of British Columbia, the University of California at Irvine, the University of Illinois at Urbana-Champaign, the University of Iowa, the University of Wyoming, the 2000 Derivatives Securities Conference at Boston University, and the 1999 Frank Batten Young Scholars Conference at the College of William and Mary for useful comments. Yu acknowledges the support of a Sage Graduate Fellowship from Cornell University while part of this research was completed.


ABSTRACT

Motivated by recent financial crises in East Asia and the United States where the downfall of a small number of firms had an economy-wide impact, this paper generalizes existing reduced-form models to include default intensities dependent on the default of a counterparty. In this model, firms have correlated defaults due not only to an exposure to common risk factors, but also to firm-specific risks that are termed “counterparty risks.” Numerical examples illustrate the effect of counterparty risk on the pricing of defaultable bonds and credit derivatives such as default swaps.

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