MULTI-FACTOR APPROACH FOR PRICING BASKET CREDIT LINKED NOTES UNDER ISSUER DEFAULT RISK

This article proposes a multi-factor approach to incorporate issuer default risk into basket credit linked note (BCLN) pricing based on the Gaussian copula. The numerical analysis demonstrates that the issuer default risk increases the fair coupon rate. Contradicting the common belief that a positive default correlation between reference entities and an issuer increases the possibility of double losses and disfavors the BCLN holder, thereby driving up the BCLN coupon rate, analytical results reveal that a positively correlated issuer default mitigates this increase, while a negatively correlated issuer default increases the coupon rate further.