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Price Calibration of basket default swap: Evidence from Japanese market

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  • Fathi, Abid
  • Nader, Naifar
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    Abstract

    The aim of this paper is the price calibration of basket default swap from Japanese market data. The value of this instruments depend on the number of factors including credit rating of the obligors in the basket, recovery rates, intensity of default, basket size and the correlation of obligors in the basket. A fundamental part of the pricing framework is the estimation of the instantaneous default probabilities for each obligor. Because default probabilities depend on the credit quality of the considered obligor, well-calibrated credit curves are a main ingredient for constructing default times. The calibration of credit curves take into account internal information on credit migrations and default history. We refer to Japan Credit Rating Agency to obtain rating transition matrix and cumulative default rates. Default risk is often considered as a rare-event and then, many studies have shown that many distributions have fatter tails than those captured by the normal distribution. Subsequently, the choice of copula and the choice of procedures for rare-event simulation govern the pricing of basket credit derivatives. Joshi and Kainth (2004) introduced an Importance Sampling technique for rare-event that forces a predetermined number of defaults to occur on each path. We consider using Gaussian copula and t-student copula and study their impact on basket credit derivative prices. We will present an application of the Canonical Maximum Likelihood Method (CML) for calibrating t-student copula to Japanese market data.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 6013.

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    Date of creation: 25 Sep 2007
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    Handle: RePEc:pra:mprapa:6013

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    Related research

    Keywords: Basket Default Swaps; Credit Curve; Monte Carlo method; Gaussian copula; t-student copula; Japanese market data; CML; Importance Sampling;

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    1. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
    2. Mark Joshi & Dherminder Kainth, 2004. "Rapid and accurate development of prices and Greeks for nth to default credit swaps in the Li model," Quantitative Finance, Taylor & Francis Journals, vol. 4(3), pages 266-275.
    3. Bouye, Eric & Durlleman, Valdo & Nikeghbali, Ashkan & Riboulet, Gaƫl & Roncalli, Thierry, 2000. "Copulas for finance," MPRA Paper 37359, University Library of Munich, Germany.
    4. Fathi Abid & Nader Naifar, 2006. "Credit-default swap rates and equity volatility: a nonlinear relationship," Journal of Risk Finance, Emerald Group Publishing, vol. 7(4), pages 348-371, August.
    5. Sosa Navarro, Ramiro, 2005. "Default Recovery Rates and Implied Default Probability Estimations: Evidence from the Argentinean Crisis," MPRA Paper 11054, University Library of Munich, Germany.
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