Revisiting Interest Rate Swap Valuation with Counterparty Risk, Wrong-Way Risk and OIS Discount

Ayoub Gargouri, Van Son Lai and Issouf Soumaré

No 2016-003, Working Papers from Department of Research, Ipag Business School

Abstract: This paper extends extant valuation models of interest rate swaps (IRS) with counterparty credit risk by accounting for wrong-way risk and OIS discounting. The proposed model extends Brigo and Pallavicini?s (2007) and Ruiz et al.?s (2013) models, by capturing wrong-way risk in the CVA calculation by way of the correlation between the intensity of default of the counterparty and the market interest rate. Under the proposed noarbitrage pricing model, cash flows are discounted using the OIS rates (mostly used by market practitioners following the 2007-2009 credit crisis), a proxy for risk-free rates. We therefore propose a unified framework that captures under one umbrella: CVA, wrong-way risk, and OIS discounting. The model parameters are estimated using real market data. Our findings indicate that it is important to account for both counterparty and wrong-way risk in IRS valuation since the two phenomena have non-negligible impacts on the CVA value. Also, using the OIS rates as risk-free discount rates, our model yields adjustment values higher than those obtained with the traditional Libor discount rates.

Keywords: Interest Rate Swap; Counterparty Credit Risk; Credit Value Adjustment (CVA); Wrong-Way Risk; Overnight Indexed Swap (OIS) (search for similar items in EconPapers)
Pages: 35 pages
Date: 2016-01-01
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Citations: View citations in EconPapers (1)

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