IDEAS home Printed from https://ideas.repec.org/a/rsk/journ1/2400755.html
   My bibliography  Save this article

The relationship between counterparty default and interest rate volatility and its impact on the credit risk of interest rate derivatives

Author

Listed:
  • Geoffrey R. Harris
  • Tao L. Wu and Jiarui Yang

Abstract

ABSTRACT We present a unified framework to study the effect of the correlation between interest rate volatility and counterparty default probability on the credit risk of collateralized interest rate derivatives contracts. When interest rates are volatile, counterparties are potentially more likely to default. Large moves in interest rates accompanied by counterparty default may lead to losses on interest rate derivatives, even if they are collateralized. An interest rate model with stochastic volatility and a reducedform default model, in which the default probability is correlated with interest rate volatility, are proposed and estimated from market data.We then analyze the effect of the correlation between interest rate volatility and a counterparty's default probability on the credit risk of collateralized interest rate derivatives contracts. Our results show that ignoring this correlation underestimates the credit risk, even with collateralized trades.

Suggested Citation

  • Geoffrey R. Harris & Tao L. Wu and Jiarui Yang, . "The relationship between counterparty default and interest rate volatility and its impact on the credit risk of interest rate derivatives," Journal of Credit Risk, Journal of Credit Risk.
    • Handle: RePEc:rsk:journ1:2400755
    as

    Download full text from publisher

    File URL: https://www.risk.net/journal-of-credit-risk/2400755/the-relationship-between-counterparty-default-and-interest-rate-volatility-and-its-impact-on-the-credit-risk-of-interest-rate-derivatives
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
    2. Moraleda, Juan M. & Vorst, Ton C. F., 1997. "Pricing American interest rate claims with humped volatility models," Journal of Banking & Finance, Elsevier, vol. 21(8), pages 1131-1157, August.
    3. Cheridito, Patrick & Filipovic, Damir & Kimmel, Robert L., 2007. "Market price of risk specifications for affine models: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 83(1), pages 123-170, January.
    4. Clifford A. Ball & Walter N. Torous, 1999. "The Stochastic Volatility of Short‐Term Interest Rates: Some International Evidence," Journal of Finance, American Finance Association, vol. 54(6), pages 2339-2359, December.
    5. Qiang Dai & Kenneth J. Singleton, 2000. "Specification Analysis of Affine Term Structure Models," Journal of Finance, American Finance Association, vol. 55(5), pages 1943-1978, October.
    6. Mercurio, F. & Moraleda, J. M., 2000. "An analytically tractable interest rate model with humped volatility," European Journal of Operational Research, Elsevier, vol. 120(1), pages 205-214, January.
    7. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-489, October.
    8. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
    9. Darrell Duffie & Rui Kan, 1996. "A Yield‐Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406, October.
    10. Jason Z. Wei, 1997. "A simple approach to bond option pricing," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 17(2), pages 131-160, April.
    11. Pierre Collin‐Dufresne & Robert S. Goldstein, 2002. "Do Bonds Span the Fixed Income Markets? Theory and Evidence for Unspanned Stochastic Volatility," Journal of Finance, American Finance Association, vol. 57(4), pages 1685-1730, August.
    12. Damiano Brigo & Aurélien Alfonsi, 2005. "Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model," Finance and Stochastics, Springer, vol. 9(1), pages 29-42, January.
    13. Casassus, Jaime & Collin-Dufresne, Pierre & Goldstein, Bob, 2005. "Unspanned stochastic volatility and fixed income derivatives pricing," Journal of Banking & Finance, Elsevier, vol. 29(11), pages 2723-2749, November.
    14. Peter Ritchken & L. Sankarasubramanian, 1995. "Volatility Structures Of Forward Rates And The Dynamics Of The Term Structure1," Mathematical Finance, Wiley Blackwell, vol. 5(1), pages 55-72, January.
    15. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    Full references (including those not matched with items on IDEAS)

    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. Anders B. Trolle & Eduardo S. Schwartz, 2009. "A General Stochastic Volatility Model for the Pricing of Interest Rate Derivatives," The Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 2007-2057, May.
    2. Samuel Chege Maina, 2011. "Credit Risk Modelling in Markovian HJM Term Structure Class of Models with Stochastic Volatility," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1-2011, January-A.
    3. Samuel Chege Maina, 2011. "Credit Risk Modelling in Markovian HJM Term Structure Class of Models with Stochastic Volatility," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 5, July-Dece.
    4. Chiarella, Carl & Kang, Boda & Nikitopoulos, Christina Sklibosios & Tô, Thuy-Duong, 2013. "Humps in the volatility structure of the crude oil futures market: New evidence," Energy Economics, Elsevier, vol. 40(C), pages 989-1000.
    5. Anders B. Trolle & Eduardo S. Schwartz, 2006. "Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives," NBER Working Papers 12744, National Bureau of Economic Research, Inc.
    6. repec:wyi:journl:002109 is not listed on IDEAS
    7. Robert A. Jarrow, 2009. "The Term Structure of Interest Rates," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 69-96, November.
    8. Frank De Jong & Joost Driessen & Antoon Pelsser, 2001. "Libor Market Models versus Swap Market Models for Pricing Interest Rate Derivatives: An Empirical Analysis," Review of Finance, European Finance Association, vol. 5(3), pages 201-237.
    9. Max F. Schöne & Stefan Spinler, 2017. "A four-factor stochastic volatility model of commodity prices," Review of Derivatives Research, Springer, vol. 20(2), pages 135-165, July.
    10. Almeida, Caio & Vicente, José, 2009. "Identifying volatility risk premia from fixed income Asian options," Journal of Banking & Finance, Elsevier, vol. 33(4), pages 652-661, April.
    11. Carl Chiarella & Boda Kang & Christina Sklibosios Nikitopoulos & Thuy‐Duong Tô, 2016. "The Return–Volatility Relation in Commodity Futures Markets," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 36(2), pages 127-152, February.
    12. Adrian, Tobias & Crump, Richard K. & Moench, Emanuel, 2013. "Pricing the term structure with linear regressions," Journal of Financial Economics, Elsevier, vol. 110(1), pages 110-138.
    13. Anders B. Trolle & Eduardo S. Schwartz, 2009. "Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives," The Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4423-4461, November.
    14. Matsumura, Marco & Moreira, Ajax & Vicente, José, 2011. "Forecasting the yield curve with linear factor models," International Review of Financial Analysis, Elsevier, vol. 20(5), pages 237-243.
    15. Li, Haitao & Ye, Xiaoxia & Yu, Fan, 2020. "Unifying Gaussian dynamic term structure models from a Heath–Jarrow–Morton perspective," European Journal of Operational Research, Elsevier, vol. 286(3), pages 1153-1167.
    16. Christensen, Bent Jesper & Kjær, Mads Markvart & Veliyev, Bezirgen, 2023. "The incremental information in the yield curve about future interest rate risk," Journal of Banking & Finance, Elsevier, vol. 155(C).
    17. Falini, Jury, 2010. "Pricing caps with HJM models: The benefits of humped volatility," European Journal of Operational Research, Elsevier, vol. 207(3), pages 1358-1367, December.
    18. Driessen, Joost & Klaassen, Pieter & Melenberg, Bertrand, 2003. "The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(3), pages 635-672, September.
    19. Collin-Dufresne, Pierre & Goldstein, Robert S. & Jones, Christopher S., 2009. "Can interest rate volatility be extracted from the cross section of bond yields?," Journal of Financial Economics, Elsevier, vol. 94(1), pages 47-66, October.
    20. Mark Broadie & Jerome B. Detemple, 2004. "ANNIVERSARY ARTICLE: Option Pricing: Valuation Models and Applications," Management Science, INFORMS, vol. 50(9), pages 1145-1177, September.
    21. Realdon, Marco, 2009. ""Extended Black" term structure models," International Review of Financial Analysis, Elsevier, vol. 18(5), pages 232-238, December.

    More about this item

    Statistics

    Access and download statistics

    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:rsk:journ1:2400755. 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: Thomas Paine (email available below). General contact details of provider: https://www.risk.net/journal-of-credit-risk .

    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.