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Counterparty credit risk and the effectiveness of banking regulation

Author

Listed:
  • Iman van Lelyveld
  • Sinziana Kroon

Abstract

We investigate how counterparty credit risk influences the prices of over-the-counter CDS contracts using confidential transaction level data for practically all Dutch trades. We confirm our prior of a significant negative relationship between the credit worthiness of the CDS seller and the price of the CDS contract. We find that an increase of 100 basis points in the credit spread of the seller, decreases the price of the CDS contract by 7.2 basis points. Also, the larger the size of the CDS contract the lower the price of the CDS contract. Finally, we find that regulatory exemptions have a statistically significant but economically negligible impact on CDS pricing: Transactions exempted from banking capital requirements for Credit Valuation Adjustment risk - mostly banks transacting with non-financial institutions, sovereigns and pension funds - trade 0.14 basis points lower, all else equal.

Suggested Citation

  • Iman van Lelyveld & Sinziana Kroon, 2018. "Counterparty credit risk and the effectiveness of banking regulation," DNB Working Papers 599, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:599
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    File URL: https://www.dnb.nl/en/binaries/Working%20Paper%20No.%20599_tcm47-377137.pdf
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    References listed on IDEAS

    as
    1. Anouk Levels & René de Sousa van Stralen & Sînziana Kroon Petrescu & Iman van Lelyveld, 2018. "CDS market structure and risk flows: the Dutch case," DNB Working Papers 592, Netherlands Central Bank, Research Department.
    2. Nicholas Vause, 2010. "Counterparty risk and contract volumes in the credit default swap market," BIS Quarterly Review, Bank for International Settlements, December.
    3. Harald Hau & Peter Hoffmann & Sam Langfield & Yannick Timmer, 2017. "Discriminatory Pricing of Over-the-Counter Derivatives," Swiss Finance Institute Research Paper Series 17-70, Swiss Finance Institute.
    4. 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.
    5. Manmohan Singh & Miguel A. Segoviano Basurto, 2008. "Counterparty Risk in the Over-The-Counter Derivatives Market," IMF Working Papers 08/258, International Monetary Fund.
    6. Jorge Abad & Iñaki Aldasoro & Christoph Aymanns & Marco D'Errico & Linda Fache Rousová & Peter Hoffmann & Sam Langfield & Martin Neychev & Tarik Roukny, 2016. "Shedding light on dark markets: First insights from the new EU-wide OTC derivatives dataset," ESRB Occasional Paper Series 11, European Systemic Risk Board.
    7. Marco D'Errico & Tarik Roukny, 2017. "Compressing Over-the-Counter Markets," Papers 1705.07155, arXiv.org.
    8. D'Errico, Marco & Roukny, Tarik, 2017. "Compressing over-the-counter markets," ESRB Working Paper Series 44, European Systemic Risk Board.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    OTC market; counterparty credit risk; credit default swap;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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