VALUING DEFAULT SWAPS ON CORRELATED LMM PROCESSES

摘要

The paper derives a model with a closed form solution for valuing default swaps including reference asset - counterparty default correlation. The model is based on three LMM (Libor Market Model) processes. One LMM process simulates risk-free short interest rates. Two more LMM processes simulate the reference asset default process and the counterparty default process. The default correlation between the reference asset and the counterparty is incorporated in two quadruple trees. One tree represents the default swap payoff of the default swap seller; the other tree represents the default swap premium payments of the default swap buyer. Swap valuation techniques are then applied to derive the fair default swap price. A Visual Basic open source code version of the model is provided.