Bilateral Defaultable Financial Derivatives Pricing and Credit Valuation Adjustment

Xiao, Tim (2019): Bilateral Defaultable Financial Derivatives Pricing and Credit Valuation Adjustment.

Abstract

The one-side defaultable financial derivatives valuation problems have been studied extensively, but the valuation of bilateral derivatives with asymmetric credit qualities is still lacking convincing mechanism. This paper presents an analytical model for valuing derivatives subject to default by both counterparties. The default-free interest rates are modeled by the Market Models, while the default time is modeled by the reduced-form model as the first jump of a time-inhomogeneous Poisson process. All quantities modeled are market-observable. The closed-form solution gives us a better understanding of the impact of the credit asymmetry on swap value, credit value adjustment, swap rate and swap spread.

• Item Type: MPRA Paper
• Language: English
• Keywords: bilateral defaultable derivatives, credit asymmetry, market models, Black model, LIBOR market model, reduced-form model, credit valuation adjustment, swap spread.
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C52 - Model Evaluation, Validation, and Selection; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling; D - Microeconomics > D4 - Market Structure, Pricing, and Design; D - Microeconomics > D4 - Market Structure, Pricing, and Design > D46 - Value Theory; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

References

ArVanities, A., and Gregory, J., 2001, Credit: the complete guide to pricing, hedging and risk management, Risk Books.

Duffie, D. and Huang, M., 1996, Swap rates and credit quality, Journal of Finance, 51, 921-949.

Duffie, D. and Singleton, K.J., 1997, An econometric model of the term structure of interest rate swap yields, Journal of Finance, 52, 1287-1321

FinPricing, 2019, Derivatives trading and risk management solution, https://finpricing.com/product.html

Huge, B. and Lando, D., 1999, Swap pricing with two-sided default risk in a rating-based model, European Finance Review, 3, 239-268.

Hubner, G., 2001, The analytic pricing of asymmetric defaultable swaps, Journal of Banking & Finance, 25, 295-316

Jarrow, R. and Turnbull, S., 1995, Pricing options on financial securities subject to default risk, Journal of Finance, 50, 53-86.

Li, H., 1998, Pricing of swaps with default risk, Review of Derivatives Research, 2, 231-250.

Longstaff, F.A. and Schwartz, E.S., 1993, Valuing risky debt: a new approach, working paper, The Anderson Graduate School of Management, UCLA.

Rendleman, R.J., 1992, How risks are shared in interest rate swaps, Journal of Financial Services Research, 7, 5-34.

Sundarean, S., 1991, Valuation of swaps, in Recent Developments in International Banking and Finance, S. Khoury, ed. Amsterdam: North Holland.

Tang, Y. and Li, B., 2007, Quantitative analysis, derivatives modeling, and trading strategies, World Scientific Publishing.