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The Implications of Tail Dependency Measures for Counterparty Credit Risk Pricing

Author

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  • J. C. Arismendi-Zambrano

    (Department of Economics, Finance and Accounting, Maynooth University, Ireland & ICMA Centre, Henley Business School, University of Reading, Whiteknights, Reading, United Kingdom.)

  • Vladimir Belitsky

    (cUniversity of São Paulo, Institute of Mathematics and Statistics, Department of Statistic, São Paulo, 05508–090, Brazil.)

  • Vinicius Amorim Sobreiro

    (University of Brasília, Department of Management, Campus Darcy Ribeiro, Brasília, 70910–900, Brazil.)

  • Herbert Kimura

    (University of Brasília, Department of Management, Campus Darcy Ribeiro, Brasília, 70910–900, Brazil.)

Abstract

This paper investigates the counterparty credit risk of interest rate swaps positions using the credit valuation adjustment (CVA) measure, and examines the potential dependency relationships between the probability of default (PD) and exposure at default (EAD). We empirically tested, using interest rate swaption implied market volatilities, three tail dependency models: a Basel III Committee independent model, a Gaussian copula dependent model, and a Wrong Way Risk (WWR) with copula dependency approach. The results show that the CVA underestimation when using a Gaussian copula for modelling the dependence of PD and EAD is about 51%–362% compared to using WWR, and the underestimation between using the standardised Basel independent model and using the Gaussian copula is about 527%–1609%, including the period of the 2007/2008 crisis. This has important implications for regulators, financial institutions, and credit risk managers when calculating counterparty risk.

Suggested Citation

  • J. C. Arismendi-Zambrano & Vladimir Belitsky & Vinicius Amorim Sobreiro & Herbert Kimura, 2020. "The Implications of Tail Dependency Measures for Counterparty Credit Risk Pricing," Economics Department Working Paper Series n306-20.pdf, Department of Economics, National University of Ireland - Maynooth.
    • Handle: RePEc:may:mayecw:n306-20.pdf
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    More about this item

    Keywords

    Credit risk; Counterparty Credit Risk; Credit Value Adjustment; Dependency of credit risk components; Pricing swaps.;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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