Modeling issuer default risk in basket default swaps: the impact of default correlation

Po-Cheng Wu

Abstract

ABSTRACT

A basket default swap (BDS) is a commonly traded instrument for the hedging and investment of a credit portfolio. Because of the fluctuation of the global financial environment, concern about the issuer default risk involved in a BDS contract is dramatically increased. A one-factor copula model is the most popular model for credit derivative pricing. However, when considering issuer default risk, this model may be inaccurate in determining the effect of the issuer default risk on a BDS. This paper discusses the bias that may be present in the pricing of a vulnerable BDS under the one-factor copula model, and also constructs a multifactor copula framework to show how issuer default risk affects BDS rates. The results of this research reveal that issuer default risk might affect the fair BDS rate in a more dramatic way than is commonly understood by investors. To appraise the risk of a vulnerable BDS, the default correlations between issuer and reference entities must be considered in the model.