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Dangers of Bilateral Counterparty Risk: the fundamental impact of closeout conventions

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  • Damiano Brigo
  • Massimo Morini

Abstract

We analyze the practical consequences of the bilateral counterparty risk adjustment. We point out that past literature assumes that, at the moment of the first default, a risk-free closeout amount will be used. We argue that the legal (ISDA) documentation suggests in many points that a substitution closeout should be used. This would take into account the risk of default of the survived party. We show how the bilateral counterparty risk adjustment changes strongly when a substitution closeout amount is considered. We model the two extreme cases of default independence and co-monotonicity, which highlight pros and cons of both risk free and substitution closeout formulations, and allow us to interpret the outcomes as dramatic consequences on default contagion. Finally, we analyze the situation when collateral is present.

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File URL: http://arxiv.org/pdf/1011.3355
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Bibliographic Info

Paper provided by arXiv.org in its series Papers with number 1011.3355.

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Date of creation: Nov 2010
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Handle: RePEc:arx:papers:1011.3355

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Web page: http://arxiv.org/

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  1. Damiano Brigo & Kyriakos Chourdakis, 2009. "Counterparty Risk For Credit Default Swaps: Impact Of Spread Volatility And Default Correlation," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(07), pages 1007-1026.
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Cited by:
  1. Damiano Brigo, 2011. "Counterparty Risk FAQ: Credit VaR, PFE, CVA, DVA, Closeout, Netting, Collateral, Re-hypothecation, WWR, Basel, Funding, CCDS and Margin Lending," Papers 1111.1331, arXiv.org, revised Jun 2012.
  2. Damiano Brigo & Cristin Buescu & Massimo Morini, 2011. "Impact of the first to default time on Bilateral CVA," Papers 1106.3496, arXiv.org.
  3. Claudio Albanese & Damiano Brigo & Frank Oertel, 2013. "Restructuring Counterparty Credit Risk," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 16(02), pages 1350010-1-1.
  4. Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2011. "Funding Valuation Adjustment: a consistent framework including CVA, DVA, collateral,netting rules and re-hypothecation," Papers 1112.1521, arXiv.org, revised Dec 2011.
  5. Zhou, Richard, 2010. "Counterparty Risk Subject To ATE," MPRA Paper 27782, University Library of Munich, Germany.
  6. Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2012. "Funding, Collateral and Hedging: uncovering the mechanics and the subtleties of funding valuation adjustments," Papers 1210.3811, arXiv.org, revised Dec 2012.
  7. Zhou, Richard, 2010. "Counterparty Risk Subject To ATE," MPRA Paper 28067, University Library of Munich, Germany.
  8. Lorenzo Giada & Claudio Nordio, 2012. "Bilateral Credit Valuation Adjustment of an Optional Early Termination Clause," Papers 1205.2013, arXiv.org, revised Jan 2013.

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