Bilateral Counterparty Risk Valuation with Stochastic Dynamical Models and Application to Credit Default Swaps

By Damiano Brigo, Agostino Capponi. 2008

117 citations recorded by the source corpus.

We introduce the general arbitrage-free valuation framework for counterparty risk adjustments in presence of bilateral default risk, including default of the investor. We illustrate the symmetry in the valuation and show that the adjustment involves a long position in a put option plus a short position in a call option, both with zero strike and written on the residual net value of the contract at the relevant default times. We allow for correlation between the default times of the investor, counterparty and underlying portfolio risk factors. We use arbitrage-free stochastic dynamical models. We then specialize our analysis to Credit Default Swaps (CDS) as underlying portfolio, generalizing the work of Brigo and Chourdakis (2008) [5] who deal with unilateral and asymmetric counterparty risk. We introduce stochastic intensity models and a trivariate copula function on the default times exponential variables to model default dependence. Similarly to [5], we find that both default correlation and credit spread volatilities have a relevant and structured impact on the adjustment. Differently from [5], the two parties will now agree on the credit valuation adjustment. We study a case involving British Airways, Lehman Brothers and Royal Dutch Shell, illustrating the bilateral adjustments in concrete crisis situations.

Subfields: Finance

View Paper: https://www.semanticscholar.org/paper/a48513751c4d3fc5eb141588daf531d977317004

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Citations in the corpus

Counterparty Risk and Funding: A Tale of Two Puzzles (2014, background): “We refer the reader to Part IV or to Brigo and Chourdakis (2008), Brigo and Capponi (2008a), Lipton and Sepp (2009a), Blanchet-Scalliet and Patras (2008) regarding possible approaches to appropriately deal with counterparty risk on credit derivatives (or strong wrong-way risk more generally).”
Optimal investment with counterparty risk: a default-density modeling approach (2009, background): “For the credit derivative CDS, Brigo and Capponi [5] have considered the case where not only the underlying credit name, but also the transaction counterparty (buyer or seller of CDS) may default.”
ARBITRAGE‐FREE BILATERAL COUNTERPARTY RISK VALUATION UNDER COLLATERALIZATION AND APPLICATION TO CREDIT DEFAULT SWAPS (2014, methodology): “Ct = 0 for any t, then we recover the result given for example in Brigo and Capponi (2008)”