IDEAS home Printed from https://ideas.repec.org/a/wsi/ijfexx/v10y2023i02ns2424786322500372.html
   My bibliography  Save this article

On Wasserstein distances, barycenters, and the cross-section methodology for proxy credit curves

Author

Listed:
  • Matteo Michielon

    (Quantitative Analysis and Quantitative Development, ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands†Korteweg-de Vries Institute for Mathematics, University of Amsterdam, Science Park, 105-107 1098 XG Amsterdam, The Netherlands)

  • Asma Khedher

    (��Korteweg-de Vries Institute for Mathematics, University of Amsterdam, Science Park, 105-107 1098 XG Amsterdam, The Netherlands)

  • Peter Spreij

    (��Korteweg-de Vries Institute for Mathematics, University of Amsterdam, Science Park, 105-107 1098 XG Amsterdam, The Netherlands‡Institute for Mathematics, Astrophysics and Particle Physics, Radboud University Nijmegen Huygens Building, Heyendaalseweg 135, 6525 AJ Nijmegen, The Netherlands)

Abstract

The credit default swap (CDS) market plays an important role for financial institutions. This is not only for their trading activities, but also as it provides a source of information to extract default probabilities to be used for (counterparty) credit risk purposes, as for instance in credit valuation adjustment calculations. Nonetheless, the number of entities for which liquid single-name CDSs are traded is of the order of a few thousands. This requires financial institutions to employ proxy methodologies to estimate the credit risk they face when trading with counterparties for which no (liquid) CDSs are available in the market. In this paper, we propose and compare different approaches to take into account counterparty-specific information in terms of rating, region, sector, etc. at cross-sectional level to strip risk-neutral default probabilities from CDSs. This is achieved by taking into account the intrinsic probabilistic information characterizing each CDS by means of suitably-defined Wasserstein distances and barycenters. The results suggest that default probabilities are likely to be overestimated if the construction of the proxy credit curves overlooks the probability structure underlying the CDS market, potentially resulting in a too conservative counterparty credit risk pricing framework.

Suggested Citation

  • Matteo Michielon & Asma Khedher & Peter Spreij, 2023. "On Wasserstein distances, barycenters, and the cross-section methodology for proxy credit curves," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 10(02), pages 1-25, June.
    • Handle: RePEc:wsi:ijfexx:v:10:y:2023:i:02:n:s2424786322500372
    DOI: 10.1142/S2424786322500372
    as

    Download full text from publisher

    File URL: http://www.worldscientific.com/doi/abs/10.1142/S2424786322500372
    Download Restriction: Access to full text is restricted to subscribers
    File URL: https://libkey.io/10.1142/S2424786322500372?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.

    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:wsi:ijfexx:v:10:y:2023:i:02:n:s2424786322500372. 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.

    We have no bibliographic references for this item. You can help adding them by using 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: Tai Tone Lim (email available below). General contact details of provider: http://www.worldscientific.com/worldscinet/ijfe .

    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.