The implications of dependence, tail dependence, and bounds’ measures for counterparty credit risk pricing

Juan Arismendi-Zambrano, Vladimir Belitsky, Vinicius Amorim Sobreiro and Herbert Kimura
Authors registered in the RePEc Author Service: Juan Carlos Arismendi Zambrano ()

Journal of Financial Stability, 2022, vol. 58, issue C

Abstract: This paper investigates the counterparty credit risk of interest rate swaps positions using the credit valuation adjustment (CVA) measure, and examines the potential dependence relationships between the probability of default (PD) and exposure at default (EAD). We empirically tested, using interest rate swaption implied market volatilities, six tail dependence models: a Basel III Committee independent model, a Gaussian, Student’s t, Gumbel, Clayton, and a wrong way risk (WWR) copula with dependence approach. The results show that the CVA underestimation when using a Clayton copula for modelling the dependence of PD and EAD is about 10%–856% compared to using WWR, and the underestimation between using the standardised Basel independent model and using the Gaussian copula is about 552%–2621%, including the period of the 2007/2008 crisis, signalling that dependence is more important than tail dependence for CVA measurement. This has important implications for regulators, financial institutions, and credit risk managers when calculating counterparty risk.

Keywords: Credit risk; Counterparty credit risk; Credit value adjustment; Dependence of credit risk components; Pricing swaps (search for similar items in EconPapers)
JEL-codes: G10 G13 G33 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:58:y:2022:i:c:s1572308921001261

DOI: 10.1016/j.jfs.2021.100969

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