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Revisiting Interest Rate Swap Valuation with Counterparty Risk, Wrong-Way Risk and OIS Discount

Author

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  • Ayoub Gargouri
  • Van Son Lai
  • Issouf Soumaré

Abstract

This paper extends extant valuation models of interest rate swaps (IRS) with counterparty credit risk by accounting for wrong-way risk and OIS discounting. The proposed model extends Brigo and Pallavicini?s (2007) and Ruiz et al.?s (2013) models, by capturing wrong-way risk in the CVA calculation by way of the correlation between the intensity of default of the counterparty and the market interest rate. Under the proposed noarbitrage pricing model, cash flows are discounted using the OIS rates (mostly used by market practitioners following the 2007-2009 credit crisis), a proxy for risk-free rates. We therefore propose a unified framework that captures under one umbrella: CVA, wrong-way risk, and OIS discounting. The model parameters are estimated using real market data. Our findings indicate that it is important to account for both counterparty and wrong-way risk in IRS valuation since the two phenomena have non-negligible impacts on the CVA value. Also, using the OIS rates as risk-free discount rates, our model yields adjustment values higher than those obtained with the traditional Libor discount rates.

Suggested Citation

  • Ayoub Gargouri & Van Son Lai & Issouf Soumaré, 2016. "Revisiting Interest Rate Swap Valuation with Counterparty Risk, Wrong-Way Risk and OIS Discount," Working Papers 2016-003, Department of Research, Ipag Business School.
    • Handle: RePEc:ipg:wpaper:2016-003
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    References listed on IDEAS

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    1. François-Louis Michaud & Christian Upper, 2008. "What drives interbank rates? Evidence from the Libor panel," BIS Quarterly Review, Bank for International Settlements, March.
    2. Damiano Brigo & Aurélien Alfonsi, 2005. "Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model," Finance and Stochastics, Springer, vol. 9(1), pages 29-42, January.
    3. Jakub Cerny & Jiri Witzany, 2014. "Interest Rate Swap Credit Valuation Adjustment," Working Papers IES 2014/16, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised May 2014.
    4. Damiano Brigo & Andrea Pallavicini & Vasileios Papatheodorou, 2011. "Arbitrage-Free Valuation Of Bilateral Counterparty Risk For Interest-Rate Products: Impact Of Volatilities And Correlations," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 14(06), pages 773-802.
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    Cited by:

    1. 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).

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