Factor copula for defaultable basket credit derivatives

Abstract

In this article, we consider a factor copula approach for evaluating basket credit derivatives with issuer default risk and demonstrate its application in a basket credit linked note (BCLN). We generate the correlated Gaussian random numbers by using the Cholesky decomposition, and then the correlated default times can be decided by these random numbers and the reduced-form model. Finally, the fair BCLN coupon rate is obtained by the Monte Carlo simulation. We also discuss the effect of issuer default risk on BCLN. We show that the effect of issuer default risk cannot be accounted for thoroughly by considering the issuer as a new reference entity in the widely used one-factor copula model, in which constant default correlation is often assumed. A different default correlation between the issuer and the reference entities affects the coupon rate greatly and must be taken into account in the pricing model.