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Pricing Counterparty Risk Including Collateralization, Netting Rules, Re-Hypothecation And Wrong-Way Risk

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    (Department of Mathematics, Imperial College London, 180 Queen's Gate, London, SW7 2AZ, UK)



    (School of Industrial Engineering, Purdue University, 315 N. Grant Street, West Lafayette, IN 47907-2023, USA)



    (Department of Mathematics, Imperial College London, 180 Queen's Gate, London, SW7 2AZ, UK)



    (Barclays Capital, 5 The North Colonnade Canary Wharf, London, E14 4BB, UK)

This article is concerned with the arbitrage-free valuation of bilateral counterparty risk through stochastic dynamical models when collateral is included, with possible rehypothecation. The payout of claims is modified to account for collateral margining in agreement with International Swap and Derivatives Association (ISDA) documentation. The analysis is specialized to interest-rate and credit derivatives. In particular, credit default swaps are considered to show that a perfect collateralization cannot be achieved under default correlation. Interest rate and credit spread volatilities are fully accounted for, as is the impact of re-hypothecation, collateral margining frequency, and dependencies.

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Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 16 (2013)
Issue (Month): 02 ()
Pages: 1-16

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Handle: RePEc:wsi:ijtafx:v:16:y:2013:i:02:p:1350007-1-1350007-16
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