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Pricing credit default swaps with bilateral value adjustments

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  • Alexander Lipton
  • Ioana Savescu
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    Abstract

    A three-dimensional extension of the structural default model with firms' values driven by correlated diffusion processes is presented. Green's function based semi-analytical methods for solving the forward calibration problem and backward pricing problem are developed. These methods are used to analyze bilateral counterparty risk for credit default swaps and evaluate the corresponding credit and debt value adjustments. It is shown that in many realistic cases these value adjustments can be surprisingly large.

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    File URL: http://arxiv.org/pdf/1207.6049
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1207.6049.

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    Date of creation: Jul 2012
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    Handle: RePEc:arx:papers:1207.6049

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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.
    2. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    4. Hua He & William P. Keirstead & Joachim Rebholz, 1998. "Double Lookbacks," Mathematical Finance, Wiley Blackwell, vol. 8(3), pages 201-228.
    5. Bianca Hilberink & L.C.G. Rogers, 2002. "Optimal capital structure and endogenous default," Finance and Stochastics, Springer, vol. 6(2), pages 237-263.
    6. Li Chen & Damir Filipovic, 2003. "Pricing Credit Default Swaps Under Default Correlations and Counterparty Risk," Finance 0303009, EconWPA.
    7. Helen Haworth & Christoph Reisinger & William Shaw, 2008. "Modelling bonds and credit default swaps using a structural model with contagion," Quantitative Finance, Taylor & Francis Journals, vol. 8(7), pages 669-680.
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