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The Valuation of Credit Default Swap with Counterparty Risk and Collateralization

Author

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  • Tim Xiao

    (University of Toronto)

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.

Suggested Citation

  • Tim Xiao, 2019. "The Valuation of Credit Default Swap with Counterparty Risk and Collateralization," Working Papers hal-02174170, HAL.
  • Handle: RePEc:hal:wpaper:hal-02174170
    Note: View the original document on HAL open archive server: https://hal.science/hal-02174170
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    References listed on IDEAS

    as
    1. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
    2. 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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    4. Xiao, Tim, 2017. "A New Model for Pricing Collateralized Financial Derivatives," SocArXiv fvdzh, Center for Open Science.
    5. Darrell Duffie & Andreas Eckner & Guillaume Horel & Leandro Saita, 2009. "Frailty Correlated Default," Journal of Finance, American Finance Association, vol. 64(5), pages 2089-2123, October.
    6. Xiao, Tim, 2017. "A New Model for Pricing Collateralized OTC Derivatives," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 24(4), pages 8-20.
    7. Xiao, Tim, 2015. "An Accurate Solution for Credit Valuation Adjustment (CVA) and Wrong Way Risk," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 25(1), pages 84-95.
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    11. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
    12. Tim Xiao, 2015. "An Accurate Solution for Credit Valuation Adjustment and Wrong Way Risk," Post-Print hal-01810490, HAL.
    13. Stéphane Crépey, 2015. "Bilateral Counterparty Risk Under Funding Constraints—Part I: Pricing," Mathematical Finance, Wiley Blackwell, vol. 25(1), pages 1-22, January.
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    15. Jean-Paul Laurent & Jon Gregory, 2005. "Basket default swaps, CDOs and factor copulas," Post-Print hal-03679517, HAL.
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    17. Lando, David & Nielsen, Mads Stenbo, 2010. "Correlation in corporate defaults: Contagion or conditional independence?," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 355-372, July.
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    Keywords

    valuation model; credit risk modeling; collateralization; correlation; CDS 1;
    All these keywords.

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