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Working Paper
Counterparty Risk and Counterparty Choice in the Credit Default Swap Market
We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine ...
Working Paper
Efficient Monte Carlo Counterparty Credit Risk Pricing and Measurement
Counterparty credit risk (CCR), a key driver of the 2007-08 credit crisis, has become one of the main focuses of the major global and U.S. regulatory standards. Financial institutions invest large amounts of resources employing Monte Carlo simulation to measure and price their counterparty credit risk. We develop efficient Monte Carlo CCR estimation frameworks by focusing on the most widely used and regulatory-driven CCR measures: expected positive exposure (EPE), credit value adjustment (CVA), and effective expected positive exposure (EEPE). Our numerical examples illustrate that our ...
Working Paper
Does Hedging with Derivatives Reduce the Market's Perception of Credit Risk?
Risk management is the most widely-cited reason that non-financial corporations use derivatives. If hedging programs are effective, then firms using derivatives should have lower credit risk than those that do not. Surprisingly, we find that firms with derivative positions without a hedge accounting designation (typically higher basis risk) have higher CDS spreads than firms that do not hedge at all. We do not find evidence that these non-designated positions are associated with future credit realizations. We examine alternative explanations and find evidence that is consistent with a market ...
Working Paper
Un-Networking: The Evolution of Networks in the Federal Funds Market
Using a network approach to characterize the evolution of the federal funds market during the Great Recession and financial crisis of 2007-2008, we document that many small federal funds lenders began reducing their lending to larger institutions in the core of the network starting in mid-2007. But an abrupt change occurred in the fall of 2008, when small lenders left the federal funds market en masse and those that remained lent smaller amounts, less frequently. We then test whether changes in lending patterns within key components of the network were associated with increases in ...
Working Paper
Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA
Wrong way risk can be incorporated in Credit Value Adjustment (CVA) calculations in a reduced form model. Hull and White [2012] introduced a CVA model that captures wrong way risk by expressing the stochastic intensity of a counterparty's default time in terms of the financial institution's credit exposure to the counterparty. We consider a class of reduced form CVA models that includes the formulation of Hull and White and show that wrong way CVA need not exceed independent CVA. This result is based on some general properties of the model calibration scheme and a formula that we derive for ...