Counterparty risk valuation on credit-linked notes under a Markov Chain framework |
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| Affiliation: | Center for Financial Engineering,Soochow University,Suzhou 215006,China;Postdoctoral Scientific Research Station,Xiamen International Bank,Xiamen 361000,China;School of Management,Xiamen University,Xiamen 361000,China;Center for Financial Engineering,Soochow University,Suzhou 215006,China;School of Mathematical Sciences,Soochow University,Suzhou 215006,China;Center for Financial Engineering,Soochow University,Suzhou 215006,China;Business School,Chengdu University,Chengdu 610106,China;Shanghai Lixin University of Accounting and Finance,Shanghai 201620,China;Business School,Sun Yat-Sen University,Guangzhou 510275,China |
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| Abstract: | A credit-linked note(CLN) is a note paying an enhanced coupon to investors for bearing the credit risk of a reference entity. In this paper, we study the counterparty risk on CLNs under a Markov chain framework, and introduce a Markov copula model to describe joint defaults between the reference entity underlying the CLN and CLN issuer. Assuming that the respective default intensities are directly and inversely proportional to the interest rate, which follows a CIR process, we obtain the explicit formulae for CLN values through a PDE approach.Finally, credit valuation adjustment(CVA) formula is derived to price counterparty credit risk. |
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