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Dangers of Bilateral Counterparty Risk: the fundamental impact of closeout conventions

  • Damiano Brigo
  • Massimo Morini

We analyze the practical consequences of the bilateral counterparty risk adjustment. We point out that past literature assumes that, at the moment of the first default, a risk-free closeout amount will be used. We argue that the legal (ISDA) documentation suggests in many points that a substitution closeout should be used. This would take into account the risk of default of the survived party. We show how the bilateral counterparty risk adjustment changes strongly when a substitution closeout amount is considered. We model the two extreme cases of default independence and co-monotonicity, which highlight pros and cons of both risk free and substitution closeout formulations, and allow us to interpret the outcomes as dramatic consequences on default contagion. Finally, we analyze the situation when collateral is present.

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File URL: http://arxiv.org/pdf/1011.3355
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Paper provided by arXiv.org in its series Papers with number 1011.3355.

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Date of creation: Nov 2010
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Handle: RePEc:arx:papers:1011.3355
Contact details of provider: Web page: http://arxiv.org/

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  1. 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.
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