The valuation of credit default swaps including investor–counterparty–reference entity default correlation

Abstract

We extend the work of Hull and White and Kettunen and Meissner and build a credit default swap (CDS) pricing model that includes default intensities and default correlation of all three involved entities, i.e., the investor (the CDS buyer), the counter-party (the CDS seller) and the underlying reference entity. We build the model in a discrete time frame, so that the user can match the timing of CDS spread payments exactly and alter cash flows if desired. We combine two octuplet trees and use swap evaluation techniques to derive a closed-form solution for the CDS spread including default correlation of all three entities. We find that the default intensity of the investor has a strong impact on the CDS spread, whereas the default correlation of the investor with other CDS entities has a minor impact. The Matlab source code of the model is provided upon request.