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The Journal of Derivatives

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Article

A Simple Model of Correlated Defaults with Application to Repo Portfolios

Dariusz Gatarek and Juliusz Jabłecki
The Journal of Derivatives Winter 2015, 23 (2) 8-23; DOI: https://doi.org/10.3905/jod.2015.23.2.008
Dariusz Gatarek
is a professor of finance at the Systems Research Institute of the Polish Academy of Sciences in Warsaw, Poland.
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  • For correspondence: dgatarek@yahoo.co.uk
Juliusz Jabłecki
is an assistant professor of finance at Warsaw University and head of the monetary policy analysis team at the National Bank of Poland in Warsaw, Poland.
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  • For correspondence: juliusz.jablecki@nbp.pl
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Abstract

Credit risk exposure of a cash provider in a repo transaction is limited to 'double default events' when the counterparty and the issuer of the underlying collateral asset both default in a short period of time. This article presents a new and intuitive model for modeling correlated defaults, which are the key drivers of residual credit risk in repo portfolios. In the model, default times of counterparties and collateral issuers are determined by idiosyncratic and systematic factors, whereby a name defaults if it is struck by either factor for the first time. The novelty of the approach lies in representing systematic factors as increasing sequences of random variables. Such a setting allows us to precisely capture the clustering of defaults in time and build a rich dependence structure that is free of the flaws inherent in the Gaussian copula-based approaches still widely used for portfolio credit risk applications. Thanks to its general formulation, the model can be applied not only to repos, but also more broadly to pricing and risk-managing any default-correlation-sensitive instruments, e.g., credit default swaps, default swaptions, and CDOs.

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    The Journal of Derivatives: 23 (2)
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    A Simple Model of Correlated Defaults with Application to Repo Portfolios
    Dariusz Gatarek, Juliusz Jabłecki
    The Journal of Derivatives Nov 2015, 23 (2) 8-23; DOI: 10.3905/jod.2015.23.2.008

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    A Simple Model of Correlated Defaults with Application to Repo Portfolios
    Dariusz Gatarek, Juliusz Jabłecki
    The Journal of Derivatives Nov 2015, 23 (2) 8-23; DOI: 10.3905/jod.2015.23.2.008
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    • Article
      • Abstract
      • REPO RESIDUAL RISK MEASUREMENT
      • A SIMPLE FACTOR MODEL OF JOINT DEFAULTS
      • CONCLUSIONS
      • ENDNOTES
      • REFERENCES
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