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The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling

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  • Tim Xiao

    (University of Toronto)

Abstract

This article presents a comprehensive framework for valuing financial instruments subject to credit risk. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats in financial markets. We analyze how swap rates are affected by bilateral counterparty credit risk, and how CDS spreads depend on the trilateral credit risk of the buyer, seller, and reference entity in a contract. Moreover, we study the effect of collateralization on valuation, since the majority of OTC derivatives are collateralized. The model shows that a fully collateralized swap is risk-free, whereas a fully collateralized CDS is not equivalent to a risk-free one. Acknowledge: The data were provided by FinPricing at www.finpricing.com

Suggested Citation

  • Tim Xiao, 2019. "The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling," Working Papers hal-02024145, HAL.
    • Handle: RePEc:hal:wpaper:hal-02024145
    Note: View the original document on HAL open archive server: https://hal.science/hal-02024145
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    References listed on IDEAS

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    1. Michael Johannes & Suresh Sundaresan, 2007. "The Impact of Collateralization on Swap Rates," Journal of Finance, American Finance Association, vol. 62(1), pages 383-410, February.
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    Cited by:

    1. Xiao, Tim, 2013. "An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk," MPRA Paper 47104, University Library of Munich, Germany.
    2. Tim Xiao, 2015. "Is the jump-diffusion model a good solution for credit risk modelling? The case of convertible bonds," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 4(1), pages 1-25.

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    More about this item

    Keywords

    asset pricing; credit risk modeling; unilateral; bilateral; multilateral credit risk; collateralization; comvariance; comrelation; correlation;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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