Title: A structural approach to pricing credit default swaps with credit and debt value adjustments
Abstract: AbstractA multi-dimensional extension of the structural default model with rms’ values driven by di usion processes with Marshall-Olkin-inspiredcorrelation structure is presented. Semi-analytical methods for solvingthe forward calibration problem and backward pricing problem in threedimensions are developed. The model is used to analyze bilateral counter-party risk for credit default swaps and evaluate the corresponding creditand debt value adjustments. 1 Introduction The recent nancial crisis has profoundly changed the nature of credit marketsin general and correlation trading in particular. The focus has shifted fromcomplicated products, such as bespoke collateralized debt obligations (CDOs),CDOs-Squared, etc., towards simpler products, such as credit indices, collat-eralized credit default swaps (CDSs), funded single name credit-linked notes(CLNs), CDSs collateralized by a risky bond, etc, for which risks are some-what easier to understand and model. However, as recent events have shown, ifnot properly managed, the trading of even these relatively simple products cancause big losses. More details can be found in Lipton and Rennie [2011].During the crisis, it has become apparent that proper accounting for coun-terparty risk in the valuation of over-the-counter (OTC) derivatives is extremelyimportant, especially in view of the fact that some protection sellers, such asmono-line insurers and investment banks, have experienced sharply elevateddefault probabilities or even default events, the case of Lehman Brothers be-ing the prime example. Counterparty credit risk is the risk that a party to a nancial contract will default prior to its expiration and will not ful ll all ofits obligations. In principle, only OTC contracts privately negotiated betweencounterparties are subject to counterparty risk.1
Publication Year: 2012
Publication Date: 2012-06-14
Language: en
Type: preprint
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Cited By Count: 1
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