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Counterparty Credit Risk and the Credit Default Swap Market

14 Pages Posted: 6 May 2011 Last revised: 17 Dec 2012

Navneet Arora

American Century Investments

Priyank Gandhi

Mendoza College of Business, University of Notre Dame

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Date Written: March 1, 2011

Abstract

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers’ credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.

Keywords: Counterparty Credit Risk, CDS

Suggested Citation

Arora, Navneet and Gandhi, Priyank and Longstaff, Francis A., Counterparty Credit Risk and the Credit Default Swap Market (March 1, 2011). Journal of Financial Economics (JFE), Vol. 103, No. 2, 2012. Available at SSRN: https://ssrn.com/abstract=1830321 or http://dx.doi.org/10.2139/ssrn.1830321

Navneet Arora

American Century Investments ( email )

1665 Charleston Road
Mountain View, CA 94043
United States

Priyank Gandhi

Mendoza College of Business, University of Notre Dame ( email )

253 Mendoza College of Business
Notre Dame, IN 46656
United States
5746313450 (Phone)

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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