Counterparty Credit Risk in OTC Derivatives

We document how counterparty credit risk is priced in FX OTC derivatives. We employ a novel data-set of dealer-specific bid-ask quotes to analyze risk pricing using the decoupling of Swiss franc from the euro as an exogenous shock. First, the removal of the peg increased both the level of volatility and dealers' sensitivity to volatility for the FX spot prices of all currency pairs including the Swiss franc. Second, the exaggerations in Swiss francs induced dealers to price jump risks in currencies similarly pegged to the euro, e.g. the Danish krone. Finally, both effects are significantly more pronounced for riskier customers, suggesting that dealers price counterparty credit risk. Results indicate that there was a central bank-induced risk discount through credible currency pegs.

Keywords: Counterparty Credit Risk, Fixed Exchange Rate Regime, FX Swaps, Swiss Franc Decoupling Event, International Banks

JEL Classification: F33, G14, G15, G2

Suggested Citation: Suggested Citation

Balke, Florian and Barth, Andreas and Reichel, Arne and Wahrenburg, Mark, Counterparty Credit Risk in OTC Derivatives (December 1, 2019). Available at SSRN: https://ssrn.com/abstract=3498958 or http://dx.doi.org/10.2139/ssrn.3498958