Pricing Financial Derivatives Subject to Multilateral Credit Risk and Collateralization

26 Pages Posted: 28 Jun 2019

See all articles by Tim Xiao

Tim Xiao

Risk Models, BMO Capital Markets

Date Written: June 26, 2019

Abstract

This article presents a new model for valuing financial contracts subject to credit risk and collateralization. Examples include the valuation of a credit default swap (CDS) contract that is affected by the trilateral credit risk of the buyer, seller and reference entity. We show that default dependency has a significant impact on asset pricing. In fact, correlated default risk is one of the most pervasive threats in financial markets. We also show that a fully collateralized CDS is not equivalent to a risk-free one. In other words, full collateralization cannot eliminate counterparty risk completely in the CDS market.

Keywords: asset pricing; credit risk modeling; collateralization; comvariance; comrelation; correlation, CDS

JEL Classification: E44, G21, G12, G24, G32, G33, G18, G28

Suggested Citation

Xiao, Tim, Pricing Financial Derivatives Subject to Multilateral Credit Risk and Collateralization (June 26, 2019). Available at SSRN: https://ssrn.com/abstract=3410640 or http://dx.doi.org/10.2139/ssrn.3410640

Tim Xiao (Contact Author)

Risk Models, BMO Capital Markets ( email )

Canada

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