The subprime mortgage crisis reveals that defaults are contagious and highly correlated. This paper estimates the latent default correlation by credit market quotes to depict the real default correlation of the credit market. Under no-arbitrage constraints, this paper further constructs credit pricing models with considering default correlation and then provides empirical estimation results of credit default swaps. The in-sample pricing results show that the default correlations significantly affect credit risks. Especially, after considering the default correlation, the credit risk measuring performance is well improved during credit crises. In addition, the out-of-sample pricing results also reveal that the pricing errors are markedly decreased by containing default correlation. Furthermore, the pricing errors are much improved by default correlation in the most damaged industry during credit crises.
