Analysis of the Contagion Effect to the Credit Derivative Valuation

Abstract

This study explores a credit derivative pricing model with counterparty risk and the contagion effect. To compare with the standard credit derivative pricing model, we analyze the counterparty risk and the contagion effect to a kth-to-default Basket Credit Linked Note (BCLN) valuation by Monte Carlo simulation. Counterparty risk and the contagion effect show significant influence for kth-to-default BCLN valuation. Especially with high k, the BCLN pricing model with the counterparty risk and the contagion effect captures chain defaulting phenomenon successfully. It indicates the higher the kth-to-default BCLN or the lower the correlation degree within reference entities, the more significant the contagion effect becomes to the kth-to-default BCLN valuation. Parameters sensitivity analyses indicate that the coupon rates of the third-to-default BCLN are lower with the higher risk-free rate or the shorter maturity. The higher hazard rate or the lower recovery rate of reference entities results in the higher coupon rates of the third-to-default BCLN. Lastly, the hazard rate and the recovery rate of the counterparty are less sensitive to the BCLN pricing. The major contribution in this study is that the credit derivative pricing model with the contagion effect is developed to capture the default chain reaction, and the valuation performance is significant numerically.