Pricing Credit Default Swap Subject to Counterparty Risk and Collateralization


Research Paper (undergraduate), 2018
25 Pages, Grade: 10

Excerpt

ABSTRACT

This article presents a new model for valuing a credit default swap (CDS) contract that is affected by multiple credit risks of the buyer, seller and reference entity. We show that default dependency has a significant impact on asset pricing. In fact, correlated default risk is one of the most pervasive threats in financial markets. We also show that a fully collateralized CDS is not equivalent to a risk-free one. In other words, full collateralization cannot eliminate counterparty risk completely in the CDS market.

Key Words: valuation model; credit risk modeling; collateralization; correlation, CDS.

1 Introduction

There are two primary types of models that attempt to describe default processes in the literature: structural models and reduced-form (or intensity) models. Many practitioners in the credit trading arena have tended to gravitate toward the reduced-from models given their mathematical tractability.

Central to the reduced-form models is the assumption that multiple defaults are independent conditional on the state of the economy. In reality, however, the default of one party might affect the default probabilities of other parties. Collin-Dufresne et al. (2003) and Zhang and Jorion (2007) find that a major credit event at one firm is associated with significant increases in the credit spreads of other firms. Giesecke (2004), Das et al. (2006), and Lando and Nielsen (2010) find that a defaulting firm can weaken the firms in its network of business links. These findings have important implications for the management of credit risk portfolios, where default relationships need to be explicitly modeled.

The main drawback of the conditionally independent assumption or the reduced-form models is that the range of default correlations that can be achieved is typically too low when compared with empirical default correlations (see Das et al. (2007)). The responses to correct this weakness can be generally classified into two categories: endogenous default relationship approaches and exogenous default relationship approaches.

The endogenous approaches include the contagion (or infectious) models and frailty models. The frailty models (see Duffie et al. (2009), Koopman et al. (2011), etc) describe default clustering based on some unobservable explanatory variables. In variations of contagion or infectious type models (see Davis and Lo (2001), Jarrow and Yu (2001), etc.), the assumption of conditional independence is relaxed and default intensities are made to depend on default events of other entities. Contagion and frailty models fill an important gap but at the cost of analytic tractability. They can be especially difficult to implement for large portfolios.

The exogenous approaches (see Li (2000), Laurent and Gregory (2005), Hull and White (2004), Brigo et al. (2011), etc) attempt to link marginal default probability distributions to the joint default probability distribution through some external functions. Due to their simplicity in use, practitioners lean toward the exogenous ones.

Given a default model, one can value a risky derivative contract and compute credit value adjustment (CVA) that is a relatively new area of financial derivative modeling and trading. CVA is the expected loss arising from the default of a counterparty (see Brigo and Capponi (2008), Lipton and Sepp (2009), Pykhtin and Zhu (2006), Gregory (2009), Bielecki et al (2013) and Crepey (2015), etc.)

Collateralization as one of the primary credit risk mitigation techniques becomes increasingly important and widespread in derivatives transactions. According the ISDA (2013), 73.7% of all OTC derivatives trades (cleared ad non-cleared) are subject to collateral agreements. For large firms, the figure is 80.7%. On an asset class basis, 83.0% of all CDS transactions and 79.2% of all fixed income transactions are collateralized. For large firms, the figures are 96.3% and 89.4%, respectively. Previous studies on collateralization include Johannes and Sundaresan (2007), Fuijii and Takahahsi (2012), Piterbarg (2010), Bielecki, et al (2013) and Hull and White (2014), etc.

This paper presents a new framework for valuing defaultable financial contracts with or without collateral arrangements. The framework characterizes default dependencies exogenously, and models collateral processes directly based on the fundamental principals of collateral agreements. For brevity we focus on CDS contracts, but many of the points we make are equally applicable to other derivatives. CDS has trilateral credit risk, where three parties – buyer, seller and reference entity – are defaultable.

In general, a CDS contract is used to transfer the credit risk of a reference entity from one party to another. The risk circularity that transfers one type of risk (reference credit risk) into another (counterparty credit risk) within the CDS market is a concern for financial stability. Some people claim that the CDS market has increased financial contagion or even propose an outright ban on these instruments.

The standard CDS pricing model in the market assumes that there is no counterparty risk. Although this oversimplified model may be accepted in normal market conditions, its reliability in times of distress has recently been questioned. In fact, counterparty risk has become one of the most dangerous threats to the CDS market. For some time now it has been realized that, in order to value a CDS properly, counterparty effects have to be taken into account (see ECB (2009)).

We bring the concept of comvariance into the area of credit risk modeling to capture the statistical relationship among three or more random variables. Comvariance was first introduced to economics by Deardorff (1982), who used this measurement to correlate three factors in international trading. Furthermore, we define a new statistics, comrelation, as a scaled version of comvariance. Accounting for default correlations and comrelations becomes important in determining CDS premia, especially during the credit crisis. Our analysis shows that the effect of default dependencies on a CDS premium from large to small accordingly is i) the default correlation between the protection seller and the reference entity, ii) the default comrelation, iii) the default correlation between the protection buyer and the reference entity, and iv) the default correlation between the protection buyer and the protection seller. In particular, we find that the default comvariance/comrelation has substantial effects on the asset pricing and risk management, which have never been documented.

There is a significant increase in the use of collateral for CDS after the recent financial crises. Many people believe that, if a CDS is fully collateralized, there is no risk of failure to pay. Collateral posting regimes are originally designed and utilized for bilateral risk products, e.g., interest rate swap (IRS), but there are many reasons to be concerned about the success of collateral posting in offsetting the risk of CDS contracts. First, the value of CDS contracts tends to move very suddenly with big jumps, whereas the price movements of IRS contracts are far smoother and less volatile than CDS prices. Second, CDS spreads can widen very rapidly. Third, CDS contracts have many more risk factors than IRS contracts. In fact, our model shows that full collateralization cannot eliminate counterparty risk completely for a CDS contract.

The rest of this paper is organized as follows: Pricing multilateral defaultable financial contract is elaborated on in Section 2; numerical results are provided in Section 3; the conclusions are presented in Section 4. All proofs and some detailed derivations are contained in the appendices.

[...]

Excerpt out of 25 pages

Details

Title
Pricing Credit Default Swap Subject to Counterparty Risk and Collateralization
Grade
10
Author
Year
2018
Pages
25
Catalog Number
V417474
ISBN (eBook)
9783668668478
ISBN (Book)
9783668668485
File size
686 KB
Language
English
Tags
pricing, credit, default, swap, subject, counterparty, risk, collateralization
Quote paper
Alan White (Author), 2018, Pricing Credit Default Swap Subject to Counterparty Risk and Collateralization, Munich, GRIN Verlag, https://www.grin.com/document/417474

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