Bilateral Defaultable Financial Derivatives Pricing and Credit Valuation Adjustment

Abstract

The one-side defaultable financial derivatives valuation problems have been studied extensively, but the valuation of bilateral derivatives with asymmetric credit qualities is still lacking convincing mechanism. This paper presents an analytical model for valuing derivatives subject to default by both counterparties. The default-free interest rates are modeled by the Market Models, while the default time is modeled by the reduced-form model as the first jump of a time-inhomogeneous Poisson process. All quantities modeled are market-observable. The closed-form solution gives us a better understanding of the impact of the credit asymmetry on swap value, credit value adjustment, swap rate and swap spread.

Keywords: Bilateral Defaultable Derivatives, Credit Asymmetry, Market Models, Black Model, LIBOR Market Model, Reduced-Form Model, Credit Valuation Adjustment, Swap Spread

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