Counterparty Risk for Credit Default Swaps: Impact of Spread Volatility and Default Correlation

19 Pages Posted: 19 May 2008 Last revised: 5 Oct 2008

See all articles by Damiano Brigo

Damiano Brigo

Imperial College London - Department of Mathematics

Kyriakos Chourdakis

FitchSolutions; CCFEA

Multiple version iconThere are 2 versions of this paper

Date Written: May 1, 2008

Abstract

We consider counterparty risk for Credit Default Swaps (CDS) in presence of correlation between default of the counterparty and default of the CDS reference credit. Our approach is innovative in that, besides default correlation, which was taken into account in earlier approaches, we also model credit spread volatility. Stochastic intensity models are adopted for the default events, and defaults are connected through a copula function. We find that both default correlation and credit spread volatility have a relevant impact on the positive counterparty-risk credit valuation adjustment to be subtracted from the counterparty-risk free price. We analyze the pattern of such impacts as correlation and volatility change through some fundamental numerical examples, analyzing wrong-way risk in particular. Given the theoretical equivalence of the credit valuation adjustment with a contingent CDS, we are also proposing a methodology for valuation of contingent CDS on CDS.

Keywords: Counterparty Risk, Credit Valuation adjustment, Credit Default Swaps, Contingent Credit Default Swaps, Credit Spread Volatility, Default Correlation, Stochastic Intensity, Copula Functions, Wrong Way Risk

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

Suggested Citation

Brigo, Damiano and Chourdakis, Kyriakos, Counterparty Risk for Credit Default Swaps: Impact of Spread Volatility and Default Correlation (May 1, 2008). Available at SSRN: https://ssrn.com/abstract=1133559 or http://dx.doi.org/10.2139/ssrn.1133559

Damiano Brigo (Contact Author)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

Kyriakos Chourdakis

FitchSolutions ( email )

101 Finsbury Pavement
London
United Kingdom

CCFEA ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

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