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Counterparty credit risk and derivatives pricing

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  • Li, Gang
  • Zhang, Chu

Abstract

We derive a model with qualitative implications for options pricing under counterparty credit risk and provide empirical evidence using the data from the Hong Kong derivatives market during 2005–2014. We find that the log-price difference between a derivative warrant with counterparty credit risk and an otherwise identical option without counterparty credit risk is significantly and negatively associated with the credit default swap spread on the warrant issuer. We also find that the prices of out-of-the-money put warrants are more sensitive to credit risk than those of other warrants. Our results show counterparty credit risk matters for derivative pricing.

Suggested Citation

  • Li, Gang & Zhang, Chu, 2019. "Counterparty credit risk and derivatives pricing," Journal of Financial Economics, Elsevier, vol. 134(3), pages 647-668.
    • Handle: RePEc:eee:jfinec:v:134:y:2019:i:3:p:647-668
    DOI: 10.1016/j.jfineco.2019.04.011
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    Cited by:

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    7. Che Guo & Xingchun Wang, 2022. "Pricing vulnerable options under correlated skew Brownian motions," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(5), pages 852-867, May.
    8. Xingchun Wang, 2022. "Valuing fade-in options with default risk in Heston–Nandi GARCH models," Review of Derivatives Research, Springer, vol. 25(1), pages 1-22, April.
    9. Castellano, Rosella & Corallo, Vincenzo & Morelli, Giacomo, 2022. "Structural estimation of counterparty credit risk under recovery risk," Journal of Banking & Finance, Elsevier, vol. 140(C).
    10. Brøgger, Søren Bundgaard, 2022. "Dynamic risk management and asset comovement," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 60-77.
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    More about this item

    Keywords

    Counterparty credit risk; Mitigating mechanism; Options pricing with vulnerability; Derivative warrants;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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