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The Journal of Fixed Income

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Primary Article

Correlated Default Modeling with a Forest of Binomial Trees

Santhosh Bandreddi, Sanjiv Ranjan Das and Rong Fan
The Journal of Fixed Income Winter 2007, 17 (3) 38-56; DOI: https://doi.org/10.3905/jfi.2007.700212
Santhosh Bandreddi
A credit derivatives strategist at Merrill Lynch in New York, NY.
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  • For correspondence: santhosh_bandreddi@ml.com
Sanjiv Ranjan Das
A professor of finance at Santa Clara University in Santa Clara, CA.
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  • For correspondence: srdas@scu.edu
Rong Fan
The director of research at Gifford Fong Associates in Lafayette, CA.
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  • For correspondence: rfan@gfong.com
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Abstract

This paper exploits the endogenous default function framework of Das and Sundaram (2007) to develop an approach for modeling correlated default on binomial trees usually used for pricing equity options. We show how joint default contracts may be valued on these trees. The model accommodates different correlation assumptions and practical implementation considerations. Credit portfolio characteristics are examined within the model and found to be consistent with stylized empirics. Risk premia for default are computable and shown to be relatively higher for poor quality firms. Equity volatility is shown to impact correlated credit loss distributions substantially. Two kinds of default dependence are explored, one coming from default intensity correlations, and the other from further conditional dependence in defaults after accounting for intensity correlations (residual copula correlation). Both are found to impact credit loss distributions, though the absence of either makes these distributions less sensitive to correlation assumptions; on balance intensity correlations are more critical.

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The Journal of Fixed Income
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Correlated Default Modeling with a Forest of Binomial Trees
Santhosh Bandreddi, Sanjiv Ranjan Das, Rong Fan
The Journal of Fixed Income Dec 2007, 17 (3) 38-56; DOI: 10.3905/jfi.2007.700212

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Correlated Default Modeling with a Forest of Binomial Trees
Santhosh Bandreddi, Sanjiv Ranjan Das, Rong Fan
The Journal of Fixed Income Dec 2007, 17 (3) 38-56; DOI: 10.3905/jfi.2007.700212
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