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

International Journal of Theoretical and Applied Finance, Vol. 12, No. 7, pp. 1007-1026, 2009

Posted: 1 Dec 2009

See all articles by Damiano Brigo

Damiano Brigo

Imperial College London - Department of Mathematics

Kyriakos Chourdakis

University of Essex - Centre for Computational Finance and Economic Agents

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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

Suggested Citation

Brigo, Damiano and Chourdakis, Kyriakos, Counterparty Risk for Credit Default Swaps: Impact of Spread Volatility and Default Correlation. International Journal of Theoretical and Applied Finance, Vol. 12, No. 7, pp. 1007-1026, 2009. Available at SSRN: https://ssrn.com/abstract=1515575

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

University of Essex - Centre for Computational Finance and Economic Agents ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

HOME PAGE: http://www.theponytail.net

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