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Enemies or Allies: Pricing counterparty credit risk for synthetic CDO tranches

Lee, Y. and So, Leh-chyan (2013): Enemies or Allies: Pricing counterparty credit risk for synthetic CDO tranches.

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Abstract

This research aims to construct a model for pricing counterparty credit risk (CCR) for synthetic collateralized debt obligation (CDO) tranches by considering the relationship between the counterparty and the credit port- folio. A stochastic intensity model is adopted to describe the default event of the counterparty, and a two-factor Gaussian copula model is applied to account for the relationship between the counterparty and underlying credit portfolio. By analyzing the data of CDX NA IG index tranches, we �nd that the relationship has a signi�cant in uence on the credit value adjust- ment (CVA) for index tranches and, hence, that it should not be ignored when a contract is initiated. In addition, we discover that the in uence has opposite e�ects and asymmetrical magnitude with respect to the protection buyers and protection sellers.

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