PRICING COUNTERPARTY RISK INCLUDING COLLATERALIZATION, NETTING RULES, RE-HYPOTHECATION AND WRONG-WAY RISK

Damiano Brigo, Agostino Capponi (), Andrea Pallavicini and Vasileios Papatheodorou ()
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Agostino Capponi: School of Industrial Engineering, Purdue University, 315 N. Grant Street, West Lafayette, IN 47907-2023, USA
Vasileios Papatheodorou: Barclays Capital, 5 The North Colonnade Canary Wharf, London, E14 4BB, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2013, vol. 16, issue 02, 1-16

Abstract: This article is concerned with the arbitrage-free valuation of bilateral counterparty risk through stochastic dynamical models when collateral is included, with possible rehypothecation. The payout of claims is modified to account for collateral margining in agreement with International Swap and Derivatives Association (ISDA) documentation. The analysis is specialized to interest-rate and credit derivatives. In particular, credit default swaps are considered to show that a perfect collateralization cannot be achieved under default correlation. Interest rate and credit spread volatilities are fully accounted for, as is the impact of re-hypothecation, collateral margining frequency, and dependencies.

Keywords: Counterparty risk; credit valuation adjustment; collateral; margining procedure; credit-spread volatility; default correlation; wrong-way risk; gap risk (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (9)

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DOI: 10.1142/S0219024913500076

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