Semi-Analytical Valuation of Basket Credit Derivatives in Intensity-Based Models

Abstract

This paper presents a semi-analytical valuation method for basket credit derivatives in a flexible intensity-based model. Default intensities are modelled as heterogeneous, correlated affine jump-diffusions. An empirical application documents that the model fits market prices of benchmark basket credit derivatives reasonably well, consistent with the observed correlation skew. Hence, I argue, contrary to comments in the literature, that intensity-based portfolio credit risk models can be both tractable and capable of generating realistic levels of default correlation.

Keywords: credit derivatives, CDOs, default correlation, intensity-based models, affine jump-diffusions

JEL Classification: G13