Quantification of Counterparty Risk Via Bessel Bridges

Abstract:     
We construct a dynamical credit model that can be calibrated exactly to CDS quotes. Modelling the default time as the first-passage time of a credit index process to the level zero, we show that the parameters of this credit index process can be chosen such that the risk-neutral (implied) distribution of the time of default is matched. Employing this default model we develop a model for asset prices conditional on the occurrence of default at a given time. We illustrate the use of the model in estimating the expected positive exposure of an oil swap traded with an airline as counterparty.

Number of Pages in PDF File: 16

Keywords: Counterparty risk, credit risk, structural model, swap, joint equity-credit modelling

JEL Classification: G12, G33

working papers series