Pricing of Basket CDS with Bilateral Default Risk under Vasicek Model with Circular Contagion

Abstract

In this study, on the basis of basket CDS, we take into account the complex correlations among market participants and choose to use the contagion model to price basket CDS. This study assumes that a basket of reference assets is defaultable and that defaults between two counterparties are contagious. Without taking into account the default of the CDS buyer, we assume that both the interest rate and the default intensity of the reference assets follow the Vasicek model. We obtain the related probability density function by the PDE method. Under the no-arbitrage principle, we set up several scenarios to get the basket CDS pricing formula. In the numerical analysis part, we verify the validity of the formula by Monte Carlo simulation, and discuss the influence of the main parameters on the formula.