The Impact of Margin Interest on the Valuation of Credit Default Swaps

Posted: 5 Mar 2011 Last revised: 14 Nov 2012

See all articles by Yu Hang (Gabriel) Kan

Yu Hang (Gabriel) Kan

Bloomberg Tradebook; Columbia University - Department of Industrial Engineering and Operations Research (IEOR)

Claus Pedersen

Barclays Investment Bank

Date Written: March 4, 2011

Abstract

Virtually all credit default swaps (CDS) are collateralized with a daily cash settlement of the variation margin equal to the change in their mark-to-market values. We show how the interest on the variation margin (also called price alignment interest) affects the value of CDS. Specifically, we show that all CDS can be valued as the expected net present value of the premium and default contingent payments by using the same risk-neutral probability measure but different discounting rates determined by the margin interest rate (i.e., the interest rate used to compute price alignment interest) on the individual CDS. For example, if the margin interest rate is fed funds, then the discounting should be done on the overnight indexed swap (OIS) curve, and if there is no margin interest, then there should be no discounting. We show that arbitrage opportunities can occur if this valuation approach is not used. Finally, using observed market prices, we numerically demonstrate meaningful differences in CDS mark-to-mark values when the OIS curve is used for discounting instead of the customary LIBOR curve.

Keywords: Variation Margin, Collateral, Interest Rate, Credit Default Swaps, Model Calibration, Derivative Pricing

JEL Classification: G12, G13

Suggested Citation

Kan, Yu Hang and Pedersen, Claus, The Impact of Margin Interest on the Valuation of Credit Default Swaps (March 4, 2011). Journal of Derivatives, Vol. 20, No. 1, 2012, Available at SSRN: https://ssrn.com/abstract=1777196 or http://dx.doi.org/10.2139/ssrn.1777196

Yu Hang Kan (Contact Author)

Bloomberg Tradebook ( email )

731 Lexington Avenue
New York, NY 10022
United States

Columbia University - Department of Industrial Engineering and Operations Research (IEOR) ( email )

331 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

HOME PAGE: http://www.columbia.edu/~yk2246

Claus Pedersen

Barclays Investment Bank ( email )

5 The North Colonnade
London, Canary Wharf E14 4BB
United Kingdom

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