Credit default swap valuation with counterparty default risk and market risk

ABSTRACT This paper suggests a methodology for valuing credit default swaps that takes account of counterparty default risk as well as correlated market and credit risk. It incorporates market risk into determining default correlations between multiple firms using the first-passage-time approach. The model is applied to the valuation of vanilla credit default swaps with counterparty default risk and to the valuation of basket credit default swaps. The pricing error in credit default swaps can be substantial by ignoring the correlation between market risk and credit risk, as well as between counterparty credit risk and reference credit risk. The market risk as well as the correlation between market and credit risk has a varying degree of impact on default swap rates depending on swap maturity and the credit quality of the parties involved. In addition, because the sensitivity of basket credit default swap rates to market risk increases with the number of reference entities, the valuation error can be more substantial in pricing basket credit default swaps than credit default swaps with a single reference entity when market risk is ignored.