Credit Contagion: Pricing Cross-Country Risk in Brady Debt Markets
Marco Avellaneda and Lixin Wu
Credit contagion means that the credit deterioration of an entity causes
the credit deterioration of other entities. In this paper, we build and test
a continuous-time model for defaultable securities using a diffusive process
for the risk-free interest rates and a continuous-time Markov process for
the correlation of credit risks. The credit contagion, in particular,
is established by relating the transition rates of various credit ``states''.
Examples of derivatives pricing with calibrated contagion model are provided.
Initial empirical results with benchmark Brady bonds show that our model
is a viable new technique for the pricing and risk-management of credit derivatives.