Abstract

http://ssrn.com/abstract=926067
 
 

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Counterparty Risk and Contingent CDS Valuation Under Correlation Between Interest-Rates and Default


Damiano Brigo


Imperial College London - Department of Mathematics; Capco

Andrea Pallavicini


Banca IMI; Imperial College London - Department of Mathematics



Abstract:     
We consider counterparty risk for interest rate payoffs in presence of correlation between the default event and interest rates. The previous analysis of Brigo and Masetti (2006), assuming independence, is further extended to interest rate payoffs different from simple swap portfolios. A stochastic intensity model with possible jumps is adopted for the default event. We find that correlation between interest-rates and default has a relevant impact on the positive adjustment to be subtracted from the default free price to take into account counterparty risk. We analyze the pattern of such impacts as product characteristics and tenor structures change through some fundamental numerical examples.

We find the counterparty risk adjustment to decrease with the correlation for receiver payoffs, while the analogous adjustment for payer payoffs increases. The impact of correlation decreases when the default probability increases. Finally, our analysis applies naturally also to Contingent Credit Default Swaps.

Number of Pages in PDF File: 19

Keywords: counterparty risk, contingent credit default swap, hybrid products, interest-rate default correlation, risk-neutral valuation, default risk, interest-rate models, default intensity models

JEL Classification: G13

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Date posted: August 23, 2006 ; Last revised: March 31, 2008

Suggested Citation

Brigo, Damiano and Pallavicini, Andrea, Counterparty Risk and Contingent CDS Valuation Under Correlation Between Interest-Rates and Default. Available at SSRN: http://ssrn.com/abstract=926067 or http://dx.doi.org/10.2139/ssrn.926067

Contact Information

Damiano Brigo
Imperial College London - Department of Mathematics ( email )
South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
HOME PAGE: http://www.damianobrigo.it
Capco ( email )
120 Broadway, 15th Floor
New York, NY 10271
United States
HOME PAGE: http://www.capco.com/capco-insights
Andrea Pallavicini
Banca IMI ( email )
Largo Mattioli 3
Milan, MI 20121
Italy
+39 02 7261 (Phone)
HOME PAGE: http://apallavicini.it
Imperial College London - Department of Mathematics ( email )
South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
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