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. In lack of complete information, 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. Due to the unpredictable nature of defaults in our model, this updating leads to "contagious" jumps in credit spreads of business partner firms, which correspond to re-assessments of these firms' health by investors. We characterize joint default probabilities and the default dependence structure as assessed by imperfectly informed investors, where we emphasize the the modeling of dependence with copulas.

Citations

365	RB: An Introduction to Copulas - Nelsen
289	Valuing corporate securities: some effects of bond indenture provisions - Black, Cox - 1976
221	Multivariate models and dependence concepts - Joe - 1997
178	Corporate Debt Value, Bond Covenants, and Optimal Capital Structure - Leland - 1994
153	2000): “On default correlation: a copula function approach - Li
116	The Relation Between Treasury Yields and Corporate Bond Yield Spreads - Duffee - 1998
101	Financial Contagion - Allen, Gale - 2000
77	Nonparametric Statistical Inference - Gibbons, Chakraborti - 2003
45	2001) Term structure of credit spreads with incomplete accounting information - Duffie, Lando
39	Default Correlation and Credit Analysis - Lucas, J - 1995
38	Simulating Correlated Defaults, working paper - Duffie - 1998
30	2001): “Counterparty risk and the pricing of defaultable securities - Jarrow, Yu
30	Modeling default correlation in bond portfolios - Davis, Lo - 2001
25	N Gârleanu (2001): “Risk and valuation of collateralized debt obligations - Duffie
25	Historical Default Rates of Corporate Bond Issuers, 1920-1998. Working paper. Moody’s Investor Service. Returns on Debt 25 - Keenan, Shtogrin, et al. - 1999
20	2002) VaR and expected shortfall in portfolios of dependent credit risks: conceptual and practical insights - Frey, McNeil
20	2001,Copula Dependent Default Risk in Intensity Models, Working paper - Schönbucher, Schubert
14	Accounting transparency and the term structure of credit spreads - Yu - 2005
10	2000a. Valuing credit default swaps, I: No counterparty default risk - Hull, White
9	Infectious defaults, Quantitative Finance - Davis, Lo
9	Portfolio management of default risk - Kealhofer - 1998
8	A (2000b), ‘Valuing credit default swaps II: modeling default correlations - Hull, White
8	and Alan White (2000): “Valuing credit default swaps”, two parts, working paper - Hull
6	Goldstein & Jean Helwege (2002), Are jumps in corporate bond yields priced? Modeling contagion via the updating of beliefs. Working - Collin-Dufresne, Robert
5	and Daniel Straumann (2001), Correlation and dependence in risk management - Embrechts, McNeil
5	2001), Default and information. Working - Giesecke
4	2001), Modeling dependent defaults. Working - Frey, McNeil
4	2001), Default compensator, incomplete information, and the term structure of credit spreads - Giesecke
3	Lisa Goldberg (2003), Forecasting default in the face of uncertainty. Working - Giesecke
3	Credit contagion and aggregate losses. Working - Giesecke - 2002
3	Creditmetrics - technical document. RiskMetrics Publication - Gupton, Finger, et al. - 1997
3	Creditor races and contingent claims - Lambrecht, Perraudin - 1996
2	Simulating correlated defaults. Working Paper - Darrell, Singleton - 1998
2	2000, How much of the corporate - Treasury yield spread is due to credit risk?, Working Paper - Huang, Huang
2	Lando & Fan Yu (2000), Default risk and diversification: Theory and applications. Working Paper - Jarrow, David
2	2000), Modeling dependence with copulas. Dissertation - Lindskog
2	A J and Straumann - Embrechts, McNeil
2	Riboulet and T. Roncalli (2001), “Modelling dependence for credit derivatives with copulas”, Working Paper, Groupe de Recherche Opérationnelle, Crédit Lyonnais - Jouanin, Rapuch, et al.
2	Planar diffusions with applications to mathematical finance - Rebholz - 1994
1	Jingyi Zhu (2001), Modeling the distance-to-default process of a firm. Working Paper, Courant Institute - Avellaneda
1	Wixin Wu (2001), ‘Credit contagion: Pricing crosscountry risk in brady debt markets - Avellaneda
1	Denuit & Philippe Lambert (2001), Copula-type representation for random couples with bernoulli marginals. Working Paper, Institute de Statistique, Université Catholique de Louvain - Tajar, Michel
1	Modeling bonds and derivatives with default risk - David - 1997