Book contents
- Frontmatter
- Contents
- Contributors
- Introduction
- PART I DATA: THE PREREQUISITE FOR MANAGING SYSTEMIC RISK
- PART II STATISTICS AND SYSTEMIC RISK
- PART III MEASURING AND REGULATING SYSTEMIC RISK
- PART IV NETWORKS
- PART V SYSTEMIC RISK ANDMATHEMATICAL FINANCE
- PART VI COUNTERPARTY RISK AND SYSTEMIC RISK
- 19 Pricing and Mitigation of Counterparty Credit Exposures
- 20 Counterparty Contagion in Context: Contributions to Systemic Risk
- PART VII ALGORITHMIC TRADING
- PART VIII BEHAVIORAL FINANCE: THE PSYCHOLOGICAL DIMENSION OF SYSTEMIC RISK
- PART IX REGULATION
- PART X COMPUTATIONAL ISSUES AND REQUIREMENTS
- PART XI ACCOUNTING ISSUES
- References
19 - Pricing and Mitigation of Counterparty Credit Exposures
from PART VI - COUNTERPARTY RISK AND SYSTEMIC RISK
Published online by Cambridge University Press: 05 June 2013
Book contents
- Frontmatter
- Contents
- Contributors
- Introduction
- PART I DATA: THE PREREQUISITE FOR MANAGING SYSTEMIC RISK
- PART II STATISTICS AND SYSTEMIC RISK
- PART III MEASURING AND REGULATING SYSTEMIC RISK
- PART IV NETWORKS
- PART V SYSTEMIC RISK ANDMATHEMATICAL FINANCE
- PART VI COUNTERPARTY RISK AND SYSTEMIC RISK
- 19 Pricing and Mitigation of Counterparty Credit Exposures
- 20 Counterparty Contagion in Context: Contributions to Systemic Risk
- PART VII ALGORITHMIC TRADING
- PART VIII BEHAVIORAL FINANCE: THE PSYCHOLOGICAL DIMENSION OF SYSTEMIC RISK
- PART IX REGULATION
- PART X COMPUTATIONAL ISSUES AND REQUIREMENTS
- PART XI ACCOUNTING ISSUES
- References
Summary
Abstract We analyze the market price of counterparty risk and develop an arbitrage-free pricing valuation framework, inclusive of collateral mitigation. We show that the adjustment is given by the sum of option payoff terms, depending on the netted exposure, i.e. the difference between the on-default exposure and the predefault collateral account. We specialize our analysis to Interest Rates Swaps (IRS) and Credit Default Swaps (CDS) as underlying portfolio, and perform a numerical study to illustrate the impact of default correlation, collateral margining frequency, and collateral re-hypothecation on the resulting adjustment. We also discuss problems of current research interest in the counterparty risk community.
Keywords Counterparty Risk, Systemic Risk, Credit Default Swaps, Interest Rates Swaps, Default Correlation, Stochastic Intensity, Collateral Margining. AMS Classification Codes: 60H10, 60J60, 60J75, 62H20, 91B70. JEL Classification Codes: C15, C63, C65, G12, G13.
Introduction
Basel II defines the counterparty credit risk as the amount that a financial institution would lose in the event that one of its counterparties defaults before the final settlement of the transaction. Unlike a firm's exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank faces the risk of loss, the counterparty credit risk creates a bilateral risk of loss, when both parties are default sensitive. Such risk is embedded in all financial contracts which are traded over the counter, where the credit quality of counterparties plays a key role.
- Type
- Chapter
- Information
- Handbook on Systemic Risk , pp. 485 - 511Publisher: Cambridge University PressPrint publication year: 2013
References
, , and (2011). Stress testing the resilience of financial networks. International Journal of Theoretical and Applied Finance 14.Google Scholar
, , , and (2009). CVA computation for counterparty risk assesment in credit portfolio. In Credit Risk Frontiers: Subprime crisis, Pricing and Hedging, CVA, MBS, Ratings and Liquidity, , and (eds). Wiley.Google Scholar
, , and (2004). A general framework for pricing credit risk. Mathematical Finance 14 317-350.CrossRefGoogle Scholar
BIS Basel III: A global regulatory framework for more resilient banks and banking systems. Available at www.bis.org.
, and (2011). Dynamic hedging of counterparty exposure. In The Musiela Festschrift, , , and , (eds). Springer-Verlag.Google Scholar
, , and (2008). Pricing and trading credit default swaps in a hazard process model. Annals of Applied Probability 18 2495-2529.CrossRefGoogle Scholar
, , and (2010). Hedging of a credit default swaption in the CIR default intensity model. Finance and Stochastics 15 541-572.Google Scholar
, , and (2011). Counterparty risk and the impact of collateralization. Available at http://arxiv.org/pdf/1104.2625v3.
, and (2011). Structural counterparty risk valuation for CDS. In Credit Risk Frontiers: Subprime crisis, Pricing and Hedging, CVA, MBS, Ratings and Liquidity, , and (eds). Wiley.Google Scholar
, and (2005). Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model. Finance and Stochastics 9 29-42.CrossRefGoogle Scholar
, and (2010). Bilateral counterparty risk with application to CDSs. Risk Magazine, March issue.Google Scholar
, (2009). Counterparty risk for credit default swaps: Impact of spread volatility and default correlation. International Journal of Theoretical and Applied Finance, 12 (7) 1007–1026.CrossRefGoogle Scholar
, and (2006). Interest Rate Models: Theory and Practice – with Smile, Inflation and Credit, Second Edition. Springer Verlag.Google Scholar
, and (2007). Counterparty Risk under Correlation between Default and Interest Rates. In Numerical Methods for Finance, , , and (eds). Chapman and Hall.Google Scholar
, , and (2011). Liquidity modeling for credit default swaps: an overview. In Credit Risk Frontiers: Subprime crisis, Pricing and Hedging, CVA, MBS, Ratings and Liquidity, , and (eds). WileyGoogle Scholar
, , , and (2011). Collateral margining in arbitrage-free counterparty valuation adjustment including re-hypotecation and netting. Available at arxiv.org/pdf/1101.3926.
, , (2012). Arbitrage-free bilateral counterparty risk valuation under collateralization and application to Credit Default Swaps. Mathematical Finance, DOI: 10.1111/j.1467-9965.2012.00520.x.Google Scholar
, and (2012). Default and systemic risk in equilibrium. Mathematical Finance, DOI: 10.1111/mafi.12009.Google Scholar
, and (2004). Measuring and marking counterparty risk. Chapter 9 of ALMof Financial Institutions, (ed). Institutional Investor Books.Google Scholar
, , , , and (2011). Modelling, Pricing, and Hedging Counterparty Credit Exposure. Springer Verlag.Google Scholar
(2011). A BSDE approach to counterparty risk under funding constraints. Preprint available at http://grozny.maths.univ-evry.fr/pages_perso/crepey/papers/Counterparty_Funding-Crepey-SUBMITTED.pdf.
, , and . (2010). CDS with counterparty risk in a Markov chain copula model with joint defaults. In Recent Advances in Financial Engineering, , , and , (eds). World Scientific Publishing Co. Pte.Google Scholar
, , and (2010). Law of large numbers for self-exciting correlated defaults. Preprint available at http://www.hss.caltech.edu/~cvitanic/PAPERS/cmz2011.pdf.
, , , and (2009). Large portfolio losses: a dynamic contagion model, Annals of Applied Probability 19 (1) 347–394.CrossRefGoogle Scholar
, and . (2009). Heterogeneous credit portfolios and the dynamics of the aggregate losses. Stochastic Processes and their Applications 119 2913-2944.CrossRefGoogle Scholar
, and (2010). Does a central clearing counterparty reduce counterparty risk?Review of Asset Pricing Studies 1 74-95.Google Scholar
, and (2011). Collateralized CDS and default dependence – implications for the central clearing. Working paper, SSRN.com, 2011.
, , and (2009). Assessing the systemic implications of financial linkages. Global Financial Stability Report, International Monetary Fund.Google Scholar
, and (2011). Systemic risk: what defaults are telling us. Management Science 57 1387-1405.CrossRefGoogle Scholar
, and (2006). Credit contagion and aggregate losses. Journal of Economic Dynamics and Control 30 741-767.CrossRefGoogle Scholar
, , and (2011). Default clustering in large portfolios: typical and atypical events. Working Paper, Stanford University.
ISDA Credit Support Annex. Available at www.isda.com.
ISDA Guidelines for Collateral Practitioners. Available at www.isda.com.
ISDA Credit Support Protocol (2002). Available at www.isda.com.
ISDA Close-Out Amount Protocol (2009). Available at www.isda.com.
ISDA Margin survey. Available at www.isda.com.
ISDA. Market review of OTC derivative bilateral collateralization Practices (2010). Available at www.isda.com.
, and (2001). Counterparty risk and the pricing of defaultable securities. Journal of Finance 56 1765-1799.CrossRefGoogle Scholar
, , , and (2001). Modelling dependence for credit derivatives with copulas. Working paper. Groupe de Recherche Operationnelle. Credit Lyonnais.
, and (2005). Credit default swap valuation with counterparty risk. The Kyoto Economic Review 74 25-15.Google Scholar
, and (2009). Credit value adjustment for credit default swaps via the structural default model. Journal of Credit Risk 5 123-146.CrossRefGoogle Scholar
(2010). The Basel Committee's December 2009 Proposals on Counterparty Risk. Federal Reserve/FSA presentation at the International Workshop on Counterparty Risk Management and Application of CVA, Bank of Japan, June 14, 2010.
(2009). Modeling credit exposure for collateralized counterparties. Journal of Credit Risk 5 3-27.CrossRefGoogle Scholar
(2006). Credit default swaps with counterparty risk: a calibrated Markov model. Journal of Credit Risk 2 31-49.CrossRefGoogle Scholar
, and (2009). Market practices for settling derivatives in bankruptcy. ABI Journal 9 34-35.Google Scholar
- 10
- Cited by