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Counterparty Risk and Contingent CDS Valuation Under Correlation Between Interest-Rates and Default

19 Pages Posted: 23 Aug 2006 Last revised: 31 Mar 2008

Damiano Brigo

Imperial College London - Department of Mathematics

Andrea Pallavicini

Banca IMI; Imperial College London - Department of Mathematics

Abstract

We consider counterparty risk for interest rate payoffs in presence of correlation between the default event and interest rates. The previous analysis of Brigo and Masetti (2006), assuming independence, is further extended to interest rate payoffs different from simple swap portfolios. A stochastic intensity model with possible jumps is adopted for the default event. We find that correlation between interest-rates and default has a relevant impact on the positive adjustment to be subtracted from the default free price to take into account counterparty risk. We analyze the pattern of such impacts as product characteristics and tenor structures change through some fundamental numerical examples.

We find the counterparty risk adjustment to decrease with the correlation for receiver payoffs, while the analogous adjustment for payer payoffs increases. The impact of correlation decreases when the default probability increases. Finally, our analysis applies naturally also to Contingent Credit Default Swaps.

Keywords: counterparty risk, contingent credit default swap, hybrid products, interest-rate default correlation, risk-neutral valuation, default risk, interest-rate models, default intensity models

JEL Classification: G13

Suggested Citation

Brigo, Damiano and Pallavicini, Andrea, Counterparty Risk and Contingent CDS Valuation Under Correlation Between Interest-Rates and Default. Available at SSRN: https://ssrn.com/abstract=926067 or http://dx.doi.org/10.2139/ssrn.926067

Damiano Brigo

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

Andrea Pallavicini

Banca IMI ( email )

Largo Mattioli 3
Milan, MI 20121
Italy
+39 02 7261 (Phone)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

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