Motivated by recent financial crises in East Asia and the United States where the downfall of a small number of firms had an economy-wide impact, this paper gen- eralizes existing reduced-form models to include default intensities dependent on the default of a counterparty. In this model, firms have correlated defaults due not only to an exposure to common risk factors, but also to firm-specific risks that are termed "counterparty risks." Numerical examples illustrate the effect of counter- party risk on the pricing of defaultable bonds and credit derivatives such as de- fault swaps.
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