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Modelling Default Correlations in a Two-Firm Model with Dynamic Leverage Ratios

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Abstract

This article provides a generalized two-firm model of default correlation, based on the structural approach that incorporates interest rate risk. In most structural models default is driven by the firms' asset dynamics. In this article, a two-firm model of default is instead driven by the dynamic leverage ratios, which combines the measure of risks of the firms' total liabilities and assets. This article investigates analytical methods and numerical tools to solve the two-dimensional first passage time problem with time-dependent parameters. We carry out a comparative analysis of the impact of model parameters and provide some insights of their effects on joint survival probabilities and default correlations.

Suggested Citation

  • Carl Chiarella & Chi-Fai Lo & Ming Xi Huang, 2012. "Modelling Default Correlations in a Two-Firm Model with Dynamic Leverage Ratios," Research Paper Series 304, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:304
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-03/QFR-rp304.pdf
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    Keywords

    credit risk; default correlations; default probabilities; first passage time;

    JEL classification:

    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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