Counterparty Risk for CDS: Default Clustering Effects

25 Pages Posted: 26 Feb 2016 Last revised: 5 Mar 2016

See all articles by Lijun Bo

Lijun Bo

University of Science and Technology of China (USTC)

Agostino Capponi

Columbia University - Department of Industrial Engineering and Operations Research

Date Written: Februaray 27, 2016

Abstract

We derive a closed-form expression for the bilateral credit valuation adjustment of a credit default swap in presence of simultaneous defaults. We develop our analysis under a default intensity model specified by a class of three-dimensional subordinators, allowing for default dependence through common risk factors. Due to simultaneous default occurrences, the joint conditional survival probability of default times consists of both an absolutely continuous and a singular part. We explicitly characterize the corresponding densities, and perform a suitable decomposition yielding the counterparty risk prices. Our analysis indicates that simultaneous defaults have material impact on the size and directionality of the adjustments. Our findings suggest policymakers to consider default clustering when designing counterparty valuation procedures, especially during periods of financial distress.

Keywords: counterparty risk, credit default swap, default clustering

JEL Classification: C15, C63, C65, G12, G13

Suggested Citation

Bo, Lijun and Capponi, Agostino, Counterparty Risk for CDS: Default Clustering Effects (Februaray 27, 2016). Journal of Banking and Finance, Vol. 52, pp. 29-42, February 2015, Available at SSRN: https://ssrn.com/abstract=2737222

Lijun Bo

University of Science and Technology of China (USTC) ( email )

96, Jinzhai Road
Hefei, Anhui 230026
China

Agostino Capponi (Contact Author)

Columbia University - Department of Industrial Engineering and Operations Research ( email )

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