A contagion model with Markov regime-switching intensities

Abstract

We consider a two-dimensional reduced form contagion model with regime-switching interacting default intensities. The model assumes the intensities of the default times are driven by macro-economy described by a homogeneous Markov chain as well as the other default. By using the idea of ‘change of measure’ and some closed-form formulas for the Laplace transforms of the integrated intensity processes, we derive the two-dimensional conditional and unconditional joint distributions of the default times. Based on these results, we give the explicit formulas for the fair spreads of the first-to-default and second-to-default credit default swaps (CDSs) on two underlyings.

Keywords

Credit default swap (CDS) / contagion model / regime-switching / change of measure

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Higher Education Press and Springer-Verlag Berlin Heidelberg