The Relationship between Counterparty Default and Interest Rate Volatility and its Impact on the Credit Risk of Interest Rate Derivatives

36 Pages Posted: 16 Jun 2016

See all articles by Jiarui Yang

Jiarui Yang

FactSet

Tao L. Wu

Illinois Institute of Technology

Geoffrey Harris

Federal Reserve Bank of Chicago

Date Written: March 20, 2015

Abstract

We present a unified framework to study the effect of the correlation between interest rate volatility and counterparty default probability on the credit risk of collateralized interest rate derivatives contracts. When interest rates are volatile, counterparties are potentially more likely to default. Large moves in interest rates accompanied by counterparty default may lead to losses on interest rate derivatives, even if they are collateralized. An interest rate model with stochastic volatility and a reduced form default model, in which the default probability is correlated with interest rate volatility, are proposed and estimated from market data. We then analyze the effect of the correlation between interest rate volatility and a counterparty's default probability on the credit risk of collateralized interest rate derivatives contracts. Our results show that ignoring this correlation underestimates the credit risk, even with collateralized trades.

Keywords: counterparty risk, over-the-counter (OTC) derivatives, stochastic interest rate volatility, hazard rate, correlation

Suggested Citation

Yang, Jiarui and Wu, Tao L. and Harris, Geoffrey, The Relationship between Counterparty Default and Interest Rate Volatility and its Impact on the Credit Risk of Interest Rate Derivatives (March 20, 2015). Journal of Credit Risk, Vol. 11, No. 1, 2015. Available at SSRN: https://ssrn.com/abstract=2795518

Jiarui Yang (Contact Author)

FactSet ( email )

601 Merritt 7, 3rd Floor
Norwalk, CT 06851
United States

Tao L. Wu

Illinois Institute of Technology ( email )

Stuart Graduate School of Business
565 W. Adams St.
Chicago, IL 60661
United States

Geoffrey Harris

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

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