Credit Quanto Spreads

This paper presents a new modeling approach for credit quanto spreads, covering credit default swap quanto spreads, bond quanto spreads and bond redenomination spreads. Credit quanto spreads are implied from a hazard rate diffusion model and a FX rate jump diffusion model, where the jumps are triggered by defaults. Here, we additionally let the expectation of a default influence the FX rate, as would be expected with rational economic agents.The quanto spread arise from correlation between the hazard rate and FX rate and a jump in the FX rate in case of default. One source of correlation is the common macroeconomic environment governing the FX and underlying credit entities. Another source stems from the FX rate depreciation at default of the credit entity. This second source can be subdivided into the direct depreciation effect and FX rate changes arising from changes in credit default expectation by the economic agents. Correlation arising from a common macroeconomic environment, will be present for all credit entities, whereas correlation arising from movements of the FX rate at default or at changes of default expectation, will be significant only for systemically important credit entities. We find that rational agent behavior reduces the credit quanto effect which arises from FX jumps when credit defaults. Numerical results are obtained by Monte Carlo simulations. Analytically, and model independently, we find that the credit default swap quanto spread can be expressed directly in terms of bond prices and annuities and is roughly equal to the bond quanto spread