Credit/Interest Rate Hybrid Models of the Short Rate for Pricing Counterparty Risk Adjustment

41 Pages Posted: 24 Aug 2009 Last revised: 3 Feb 2010

Date Written: September 10, 2009

Abstract

This study is concerned with hybrid models of multiple stochastic processes and their use in pricing instruments whose payoffs depend on credit and interest rate variables. We introduce such a model and extend to two-factor modelling in both credit and interest rate dimensions, in order to relax the assumption of perfect correlation between survival probabilities of different tenors. We also assume that short interest and hazard rates evolve as correlated stochastic processes and apply simulation methods for pricing interest rate and credit default swaps with counterparty risk. Analytical CDS pricing formulas that consider the filtration of the simulated variables are also derived to significantly improve computational efficiency in the calibration and pricing procedures. Our numerical experiments indicate that the volatility of interest and hazard rates are significant parameters for the value of counterparty risk adjustment, while the correlation between survival probabilities with different time horizons are found to be far from perfect. These results strongly support the use of two-factor dynamic models.

Keywords: Counterparty risk, short-rate models

Suggested Citation

Kechagioglou, Ioannis, Credit/Interest Rate Hybrid Models of the Short Rate for Pricing Counterparty Risk Adjustment (September 10, 2009). 22nd Australasian Finance and Banking Conference 2009. Available at SSRN: https://ssrn.com/abstract=1460249 or http://dx.doi.org/10.2139/ssrn.1460249

Ioannis Kechagioglou (Contact Author)

Imperial College Business School ( email )

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

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