Counterparty Risk and the Pricing of Defaultable Securities

Motivated by recent financial crises in East Asia and the U.S. where the downfall of a small number of firms had an economy-wide impact, this paper generalizes existing reduced-form models to include default intensities dependent on the default of a counterparty. In this model, firms have correlated defaults due not only to an exposure to common risk factors, but also to firm-specific risks that are termed ``counterparty risks.'' Numerical examples illustrate the effect of counterparty risk on the pricing of defaultable bonds and credit derivatives such as default swaps.