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Pricing derivatives with counterparty risk and collateralization: A fixed point approach

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  • Kim, Jinbeom
  • Leung, Tim

Abstract

This paper studies a valuation framework for financial contracts subject to reference and counterparty default risks with collateralization requirement. We propose a fixed point approach to analyze the mark-to-market contract value with counterparty risk provision, and show that it is a unique bounded and continuous fixed point via contraction mapping. This leads us to develop an accurate iterative numerical scheme for valuation. Specifically, we solve a sequence of linear inhomogeneous PDEs, whose solutions converge to the fixed point price function. We apply our methodology to compute the bid and ask prices for both defaultable equity and fixed-income derivatives, and illustrate the non-trivial effects of counterparty risk, collateralization ratio and liquidation convention on the bid-ask spreads.

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  • Kim, Jinbeom & Leung, Tim, 2016. "Pricing derivatives with counterparty risk and collateralization: A fixed point approach," European Journal of Operational Research, Elsevier, vol. 249(2), pages 525-539.
    • Handle: RePEc:eee:ejores:v:249:y:2016:i:2:p:525-539
    DOI: 10.1016/j.ejor.2015.06.055
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    Cited by:

    1. Harb, Etienne & Louhichi, Wael, 2017. "Pricing CDS spreads with Credit Valuation Adjustment using a mixture copula," Research in International Business and Finance, Elsevier, vol. 39(PB), pages 963-975.
    2. Damiano Brigo & Nicola Pede & Andrea Petrelli, 2019. "Multi-Currency Credit Default Swaps," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(04), pages 1-35, June.
    3. Brigo, Damiano & Francischello, Marco & Pallavicini, Andrea, 2019. "Nonlinear valuation under credit, funding, and margins: Existence, uniqueness, invariance, and disentanglement," European Journal of Operational Research, Elsevier, vol. 274(2), pages 788-805.
    4. Cheikh Mbaye & Frédéric Vrins, 2022. "Affine term structure models: A time‐change approach with perfect fit to market curves," Mathematical Finance, Wiley Blackwell, vol. 32(2), pages 678-724, April.
    5. Christoph Belak & Daniel Hoffmann & Frank T. Seifried, 2020. "Branching Diffusions with Jumps and Valuation with Systemic Counterparties," Working Paper Series 2020-04, University of Trier, Research Group Quantitative Finance and Risk Analysis.
    6. Ballotta, Laura & Fusai, Gianluca & Marazzina, Daniele, 2019. "Integrated structural approach to Credit Value Adjustment," European Journal of Operational Research, Elsevier, vol. 272(3), pages 1143-1157.
    7. Chaofan Sun & Ken Seng Tan & Wei Wei, 2022. "Credit Valuation Adjustment with Replacement Closeout: Theory and Algorithms," Papers 2201.09105, arXiv.org, revised Jan 2022.
    8. BRIGO, Damiano & VRINS, Frédéric, 2018. "Disentangling wrong-way risk: pricing credit valuation adjustment via change of measures," European Journal of Operational Research, Elsevier, vol. 269(3), pages 1154-1164.
    9. Antonelli, Fabio & Ramponi, Alessandro & Scarlatti, Sergio, 2022. "Approximate value adjustments for European claims," European Journal of Operational Research, Elsevier, vol. 300(3), pages 1149-1161.
    10. Castellano, Rosella & Corallo, Vincenzo & Morelli, Giacomo, 2022. "Structural estimation of counterparty credit risk under recovery risk," Journal of Banking & Finance, Elsevier, vol. 140(C).

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