IDEAS home Printed from https://ideas.repec.org/a/eee/riibaf/v39y2017ipbp963-975.html
   My bibliography  Save this article

Pricing CDS spreads with Credit Valuation Adjustment using a mixture copula

Author

Listed:
  • Harb, Etienne
  • Louhichi, Wael

Abstract

Credit derivatives pricing models before Basel III ignored losses in market value stemming from higher probability of counterparty default. We propose a general credit derivatives pricing model to evaluate a Credit Default Swap (CDS) with counterparty risk, including the Credit Valuation Adjustment (CVA) in order to optimize the economic capital allocation. We work from the model proposed by Luciano (2003, Working Paper, International Center of Economic Research) and the general pricing representation established by Sorensen and Bollier (Financial Analysts Journal 1994;50(3):23–33) to provide a model close to the market practice, easy to implement and fitting with Basel III framework. We approach the dependence between counterparty risk and that of the reference entity with a technical tool: the copula, in particular, the mixture one that combines common “extreme” copulas. We study the CDS's vulnerability in extreme dependence cases. By varying Spearman's rho, the mixture copula covers a broad spectrum of dependence and ensures closed form prices. We end up with an application on real market data.

Suggested Citation

  • Harb, Etienne & Louhichi, Wael, 2017. "Pricing CDS spreads with Credit Valuation Adjustment using a mixture copula," Research in International Business and Finance, Elsevier, vol. 39(PB), pages 963-975.
    • Handle: RePEc:eee:riibaf:v:39:y:2017:i:pb:p:963-975
    DOI: 10.1016/j.ribaf.2016.02.003
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0275531916300319
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.ribaf.2016.02.003?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. S. Crépey & M. Jeanblanc & B. Zargari, 2010. "Counterparty Risk on a CDS in a Markov Chain Copula Model with Joint Defaults," World Scientific Book Chapters, in: Masaaki Kijima & Chiaki Hara & Keiichi Tanaka & Yukio Muromachi (ed.), Recent Advances In Financial Engineering 2009, chapter 4, pages 91-126, World Scientific Publishing Co. Pte. Ltd..
    2. Dong, Yinghui & Wang, Guojing, 2014. "Bilateral counterparty risk valuation for credit default swap in a contagion model using Markov chain," Economic Modelling, Elsevier, vol. 40(C), pages 91-100.
    3. Kim, Jinbeom & Leung, Tim, 2016. "Pricing derivatives with counterparty risk and collateralization: A fixed point approach," European Journal of Operational Research, Elsevier, vol. 249(2), pages 525-539.
    4. Cherubini, Umberto & Mulinacci, Sabrina & Romagnoli, Silvia, 2011. "A copula-based model of speculative price dynamics in discrete time," Journal of Multivariate Analysis, Elsevier, vol. 102(6), pages 1047-1063, July.
    5. Dong, Yinghui & Yuen, Kam C. & Wu, Chongfeng, 2014. "Unilateral counterparty risk valuation of CDS using a regime-switching intensity model," Statistics & Probability Letters, Elsevier, vol. 85(C), pages 25-35.
    6. Bo, Lijun & Capponi, Agostino, 2015. "Counterparty risk for CDS: Default clustering effects," Journal of Banking & Finance, Elsevier, vol. 52(C), pages 29-42.
    7. Michael S. Gibson, 2005. "Measuring counterparty credit exposure to a margined counterparty," Finance and Economics Discussion Series 2005-50, Board of Governors of the Federal Reserve System (U.S.).
    8. 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.
    9. Hui Li, 2013. "A Note On The Double Impact On Cva For Cds: Wrong-Way Risk With Stochastic Recovery," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 16(03), pages 1-14.
    10. 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.
    11. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
    12. U. Cherubini & E. Luciano, 2002. "Bivariate option pricing with copulas," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(2), pages 69-85.
    13. Umberto Cherubini & Elisa Luciano, 2003. "Pricing and Hedging Credit Derivatives with Copulas," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 32(2), pages 219-242, July.
    14. Damiano Brigo & Agostino Capponi & Andrea Pallavicini, 2014. "Arbitrage-Free Bilateral Counterparty Risk Valuation Under Collateralization And Application To Credit Default Swaps," Mathematical Finance, Wiley Blackwell, vol. 24(1), pages 125-146, January.
    15. Christophette Blanchet-Scalliet & Fr'ed'eric Patras, 2008. "Counterparty risk valuation for CDS," Papers 0807.0309, arXiv.org.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Gunay, Samet, 2020. "Seeking causality between liquidity risk and credit risk: TED-OIS spreads and CDS indexes," Research in International Business and Finance, Elsevier, vol. 52(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Arismendi-Zambrano, Juan & Belitsky, Vladimir & Sobreiro, Vinicius Amorim & Kimura, Herbert, 2022. "The implications of dependence, tail dependence, and bounds’ measures for counterparty credit risk pricing," Journal of Financial Stability, Elsevier, vol. 58(C).
    2. 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.
    3. Wang, Lei & Li, Shouwei & Chen, Tingqiang, 2019. "Investor behavior, information disclosure strategy and counterparty credit risk contagion," Chaos, Solitons & Fractals, Elsevier, vol. 119(C), pages 37-49.
    4. Akari, Mohamed-Ali & Ben-Abdallah, Ramzi & Breton, Michèle & Dionne, Georges, 2021. "The impact of central clearing on the market for single-name credit default swaps," The North American Journal of Economics and Finance, Elsevier, vol. 56(C).
    5. Fernandez, Viviana, 2008. "Copula-based measures of dependence structure in assets returns," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 387(14), pages 3615-3628.
    6. Castellano, Rosella & Corallo, Vincenzo & Morelli, Giacomo, 2022. "Structural estimation of counterparty credit risk under recovery risk," Journal of Banking & Finance, Elsevier, vol. 140(C).
    7. Brigo, Damiano & Francischello, Marco & Pallavicini, Andrea, 2019. "Nonlinear valuation under credit, funding, and margins: Existence, uniqueness, invariance, and disentanglement," European Journal of Operational Research, Elsevier, vol. 274(2), pages 788-805.
    8. Noureddine Benlagha, 2014. "Dependence structure between nominal and index-linked bond returns: a bivariate copula and DCC-GARCH approach," Applied Economics, Taylor & Francis Journals, vol. 46(31), pages 3849-3860, November.
    9. Damiano Brigo & Nicola Pede & Andrea Petrelli, 2019. "Multi-Currency Credit Default Swaps," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(04), pages 1-35, June.
    10. Xingchun Wang, 2022. "Valuing fade-in options with default risk in Heston–Nandi GARCH models," Review of Derivatives Research, Springer, vol. 25(1), pages 1-22, April.
    11. Calice, Giovanni, 2011. "The Impact of Collateral Policies on Sovereign CDS Spreads," ECMI Papers 12234, Centre for European Policy Studies.
    12. Frédéric Vrins, 2017. "Wrong-Way Risk Cva Models With Analytical Epe Profiles Under Gaussian Exposure Dynamics," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(07), pages 1-35, November.
    13. Qian, Qian & Feng, Hairong & Gu, Jing, 2021. "The influence of risk attitude on credit risk contagion—Perspective of information dissemination," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 582(C).
    14. Cheikh Mbaye & Frédéric Vrins, 2022. "Affine term structure models: A time‐change approach with perfect fit to market curves," Mathematical Finance, Wiley Blackwell, vol. 32(2), pages 678-724, April.
    15. BRIGO, Damiano & VRINS, Frédéric, 2018. "Disentangling wrong-way risk: pricing credit valuation adjustment via change of measures," European Journal of Operational Research, Elsevier, vol. 269(3), pages 1154-1164.
    16. St'ephane Cr'epey & Shiqi Song, 2017. "Invariance times," Papers 1702.01045, arXiv.org.
    17. Damiano Brigo & Nicola Pede & Andrea Petrelli, 2015. "Multi Currency Credit Default Swaps Quanto effects and FX devaluation jumps," Papers 1512.07256, arXiv.org, revised Jan 2018.
    18. Damiano Brigo & Kyriakos Chourdakis, 2012. "Consistent single- and multi-step sampling of multivariate arrival times: A characterization of self-chaining copulas," Papers 1204.2090, arXiv.org, revised Apr 2012.
    19. Xingchun Wang, 2016. "The Pricing of Catastrophe Equity Put Options with Default Risk," International Review of Finance, International Review of Finance Ltd., vol. 16(2), pages 181-201, June.
    20. Xiao, Tim, 2013. "The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling," MPRA Paper 47136, University Library of Munich, Germany.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:riibaf:v:39:y:2017:i:pb:p:963-975. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/ribaf .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.