Effect of Asset Value Correlation on Credit-Linked Note Values

24 Pages Posted: 8 May 2007

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

Abstract

This paper develops a simple model to study the credit risk premiums of credit-linked notes using the structural model. Closed-form solutions of credit risk premiums of the credit-linked notes derived from the model as functions of firm values and the short-term interest rate, with time-dependent model parameters governing the dynamics of the firm values and interest rate. The numerical results show that the credit spreads of a credit-linked note increase non-linearly with the decrease in the correlation between the asset values of the note issuer and the reference obligor when the final payoff condition depends on the asset values of the note issuer and the reference obligor. When the final payoff condition depends on the recovery rate of the note issuer upon default, the credit spreads could increase with the correlation. In addition, the term structures of model parameters and the correlations involving interest rate are clearly the important factors in determining the credit spreads of the notes.

Keywords: credit risk, risky bonds, contingent claim analysis

JEL Classification: C60, G13, G28

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai, Effect of Asset Value Correlation on Credit-Linked Note Values. International Journal of Theoretical and Applied Finance (2002), Vol.5, No. 5, 455-478. Available at SSRN: https://ssrn.com/abstract=984372

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

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