Post by Sapphire Capital on Jul 21, 2008 22:36:10 GMT 4
Counterparty Risk for Credit Default Swaps: Impact of Spread Volatility and Default Correlation
DAMIANO BRIGO
Fitch Solutions; Imperial College - Department of Mathematics
KYRIAKOS CHOURDAKIS
FitchSolutions; CCFEA
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May 2008
Abstract:
We consider counterparty risk for Credit Default Swaps (CDS) in presence of correlation between default of the counterparty and default of the CDS reference credit. Our approach is innovative in that, besides default correlation, which was taken into account in earlier approaches, we also model credit spread volatility. Stochastic intensity models are adopted for the default events, and defaults are connected through a copula function. We find that both default correlation and credit spread volatility have a relevant impact on the positive counterparty-risk credit valuation adjustment to be subtracted from the counterparty-risk free price. We analyze the pattern of such impacts as correlation and volatility change through some fundamental numerical examples, analyzing wrong-way risk in particular. Given the theoretical equivalence of the credit valuation adjustment with a contingent CDS, we are also proposing a methodology for valuation of contingent CDS on CDS.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1136094_code258765.pdf?abstractid=1133559&mirid=2
DAMIANO BRIGO
Fitch Solutions; Imperial College - Department of Mathematics
KYRIAKOS CHOURDAKIS
FitchSolutions; CCFEA
--------------------------------------------------------------------------------
May 2008
Abstract:
We consider counterparty risk for Credit Default Swaps (CDS) in presence of correlation between default of the counterparty and default of the CDS reference credit. Our approach is innovative in that, besides default correlation, which was taken into account in earlier approaches, we also model credit spread volatility. Stochastic intensity models are adopted for the default events, and defaults are connected through a copula function. We find that both default correlation and credit spread volatility have a relevant impact on the positive counterparty-risk credit valuation adjustment to be subtracted from the counterparty-risk free price. We analyze the pattern of such impacts as correlation and volatility change through some fundamental numerical examples, analyzing wrong-way risk in particular. Given the theoretical equivalence of the credit valuation adjustment with a contingent CDS, we are also proposing a methodology for valuation of contingent CDS on CDS.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1136094_code258765.pdf?abstractid=1133559&mirid=2