A New Default Probability Calculation Formula and Its Application under Uncertain Environments

Abstract

In the real world, corporate defaults will be affected by both external market shocks and counterparty risks. With this in mind, we propose a new default intensity model with counterparty risks based on both external shocks and the internal contagion effect. The effects of the external shocks and internal contagion on a company cannot, however, be observed, as uncertainty in the real world contains both randomness and fuzziness. This prevents us from determining the size of the shocks accurately. In this study, fuzzy set theory is utilized to study a looping default credit default swap (CDS) pricing model under uncertain environments. Following this, we develop a new fuzzy form pricing formula for CDS, the simulation analysis of which shows that all kinds of fuzziness in the market have a significant impact on credit spreads, and that the credit spreads, relative to the degree of external shock fuzziness, are much more sensitive. Nevertheless, for a certain degree of fuzziness in the market, credit spreads, relative to changes in counterparty risk, are much more sensitive. Using random analysis and fuzzy numbers, one can think of even more uncertain sources at play than the processes of looping default and investor subjective judgment on the financial markets, and this broadens the scope of possible credit spreads. Compared to the existing related literature, our new fuzzy form CDS pricing model with counterparty risk can consider more factors that influence default and is closer to the reality of the complexity of the dynamics of default. It can also employ the membership function to describe the fuzzy phenomenon, enable the fuzzy phenomenon to be estimated in two kinds of state, and can simultaneously reflect both the fuzziness and randomness in financial markets.