Default correlation has become a key issue in the trading of debt-related products. Credit spreads of individual issuers imply risk-neutral default distributions but provide little or no information about the relation between different issuers.
Several different approaches to this problem are available, based on both 'reduced form' and 'structural' models. In previous papers the author and Violet Lo introduced reduced-form `infection models' in which interaction effects can be handled in a straightforward way. The philosophy is to specify directly a mechanism by which different issuers interact, leading to readily-computable finite-state Markov models where the states represent various combinations of defaulted/non-defaulted issuers.
In this paper we consider
* Calibration of simple models and implications for counterparty default risk in default swaps. * Estimation of interaction parameters from market data. * More complex models to allow for stochastic interest and hazard rates. * Applications to pricing and hedging of basket default swaps.