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Counterparty credit risk and the credit default swap market

Author

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  • Arora, Navneet
  • Gandhi, Priyank
  • Longstaff, Francis A.

Abstract

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers' credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.

Suggested Citation

  • Arora, Navneet & Gandhi, Priyank & Longstaff, Francis A., 2012. "Counterparty credit risk and the credit default swap market," Journal of Financial Economics, Elsevier, vol. 103(2), pages 280-293.
    • Handle: RePEc:eee:jfinec:v:103:y:2012:i:2:p:280-293
    DOI: 10.1016/j.jfineco.2011.10.001
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    References listed on IDEAS

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    More about this item

    Keywords

    Counterparty credit risk; Credit default swaps; Collateralization;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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