Correlated default with incomplete information

Abstract

The recent accounting scandals at Enron, WorldCom, and Tyco were related to the misrepresentation of liabilities. We provide a structural model of correlated multi-firm default, in which public bond investors are uncertain about the liability-dependent barrier at which individual firms default. Investors form prior beliefs on the barriers, which they update with the default status information of firms arriving over time. Whenever a firm suddenly defaults, investors learn about the default threshold of closely associated business partner firms. This updating leads to “contagious” jumps in credit spreads of business partners. We characterize joint default probabilities and the default dependence structure as assessed by investors, where we emphasize the the modeling of dependence with copulas. A case study based on Brownian asset dynamics illustrates our results.