Pricing Counter-Party Risk Using Good Deal Bounds

Abstract

We analyze the problem of pricing counter-party risk for over-the-counter derivatives when there is no liquidly traded credit derivative for the counter-party. We address the market incompleteness by computing good deal bounds. We show that the lower good deal bound is a coherent risk measure and, that the good deal bound interval can be used to assess model risk. Together, these answer the question of how much the price of an OTC derivative can change due to a re-pricing of credit risk on the market or due to a change in risk attitudes and of how much we can trust the numbers we obtain from pricing counter-party risk for firms for which we do not have a liquidly traded credit derivative.

Keywords: incomplete markets, good deal bounds, vulnerable options, counterparty risk, coherent risk measure, over-the-counter derivatives market

JEL Classification: C61, G13, G19