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The implications of dependence, tail dependence, and bounds’ measures for counterparty credit risk pricing

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  • Arismendi-Zambrano, Juan
  • Belitsky, Vladimir
  • Sobreiro, Vinicius Amorim
  • Kimura, Herbert

Abstract

This paper investigates the counterparty credit risk of interest rate swaps positions using the credit valuation adjustment (CVA) measure, and examines the potential dependence relationships between the probability of default (PD) and exposure at default (EAD). We empirically tested, using interest rate swaption implied market volatilities, six tail dependence models: a Basel III Committee independent model, a Gaussian, Student’s t, Gumbel, Clayton, and a wrong way risk (WWR) copula with dependence approach. The results show that the CVA underestimation when using a Clayton copula for modelling the dependence of PD and EAD is about 10%–856% compared to using WWR, and the underestimation between using the standardised Basel independent model and using the Gaussian copula is about 552%–2621%, including the period of the 2007/2008 crisis, signalling that dependence is more important than tail dependence for CVA measurement. This has important implications for regulators, financial institutions, and credit risk managers when calculating counterparty risk.

Suggested Citation

  • Arismendi-Zambrano, Juan & Belitsky, Vladimir & Sobreiro, Vinicius Amorim & Kimura, Herbert, 2022. "The implications of dependence, tail dependence, and bounds’ measures for counterparty credit risk pricing," Journal of Financial Stability, Elsevier, vol. 58(C).
    • Handle: RePEc:eee:finsta:v:58:y:2022:i:c:s1572308921001261
    DOI: 10.1016/j.jfs.2021.100969
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    More about this item

    Keywords

    Credit risk; Counterparty credit risk; Credit value adjustment; Dependence of credit risk components; Pricing swaps;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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