A Set-Valued Markov Chain Approach to Credit Default

41 Pages Posted: 12 Sep 2018 Last revised: 6 Oct 2019

See all articles by Dianfa Chen

Dianfa Chen

Nankai University

Jun Deng

University of International Business and Economics (UIBE) - School of Banking and Finance

Jianfen Feng

University of International Business and Economics (UIBE) - School of Banking and Finance

Bin Zou

University of Connecticut - Department of Mathematics

Date Written: August 30, 2018

Abstract

We propose a novel credit default model that takes into account the impact of macroeconomic information and contagion effect on the defaults of obligors. We use a set-valued Markov chain to model the default process, which is the set of all defaulted obligors in the group. We obtain analytic characterizations for the default process, and use them to derive pricing formulas in explicit forms for synthetic collateralized debt obligations (CDOs). Furthermore, we use market data to calibrate the model and conduct numerical studies on the tranche spreads of CDOs. We find evidence to support that systematic default risk coupled with default contagion could have the leading component of the total default risk.

Keywords: credit risk; collateral default obligation (CDO); Markov chain; jump diffusion; tranche spread

Suggested Citation

Chen, Dianfa and Deng, Jun and Feng, Jianfen and Zou, Bin, A Set-Valued Markov Chain Approach to Credit Default (August 30, 2018). Available at SSRN: https://ssrn.com/abstract=3241084 or http://dx.doi.org/10.2139/ssrn.3241084

Dianfa Chen

Nankai University ( email )

94 Weijin Road
Tianjin, 300071
China

Jun Deng

University of International Business and Economics (UIBE) - School of Banking and Finance ( email )

No.10, Huixindong Street
Chaoyang District
Beijing, 100029
China

Jianfen Feng

University of International Business and Economics (UIBE) - School of Banking and Finance ( email )

No.10, Huixindong Street
Chaoyang District
Beijing, 100029
China

Bin Zou (Contact Author)

University of Connecticut - Department of Mathematics ( email )

341 Mansfield Road U1009
Department of Mathematics
Storrs, CT 06269-1069
United States

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