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Counterparty Risk For Credit Default Swaps: Impact Of Spread Volatility And Default Correlation


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    (Fitch Solutions and Dept. of Mathematics, Imperial College, 101 Finsbury Pavement, EC2A 1RS, London)


    (CCFEA, University of Essex, Wivenhoe Park, Colchester, Essex CO4 3SQ, United Kingdom)


We consider counterparty risk for Credit Default Swaps (CDS) in presence of correlation between default of the counterparty and default of the CDS reference credit. Our approach is innovative in that, besides default correlation, which was taken into account in earlier approaches, we also model credit spread volatility. Stochastic intensity models are adopted for the default events, and defaults are connected through a copula function. We find that both default correlation and credit spread volatility have a relevant impact on the positive counterparty-risk credit valuation adjustment to be subtracted from the counterparty-risk free price. We analyze the pattern of such impacts as correlation and volatility change through some fundamental numerical examples, analyzing wrong-way risk in particular. Given the theoretical equivalence of the credit valuation adjustment with a contingent CDS, we are also proposing a methodology for valuation of contingent CDS on CDS.

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Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 12 (2009)
Issue (Month): 07 ()
Pages: 1007-1026

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Handle: RePEc:wsi:ijtafx:v:12:y:2009:i:07:p:1007-1026

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Keywords: Counterparty risk; credit valuation adjustment; Credit Default Swaps; contingent credit default swaps; credit spread volatility; default correlation; stochastic intensity; copula functions; wrong way risk;


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