Preprint Article Version 1 This version is not peer-reviewed

The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling

Version 1 : Received: 29 September 2019 / Approved: 3 October 2019 / Online: 3 October 2019 (04:49:57 CEST)

How to cite: Xiao, T. The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling. Preprints 2019, 2019100038 (doi: 10.20944/preprints201910.0038.v1). Xiao, T. The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling. Preprints 2019, 2019100038 (doi: 10.20944/preprints201910.0038.v1).

Abstract

This article presents a comprehensive framework for valuing financial instruments subject to credit risk. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats in financial markets. We analyze how swap rates are affected by bilateral counterparty credit risk, and how CDS spreads depend on the trilateral credit risk of the buyer, seller, and reference entity in a contract. Moreover, we study the effect of collateralization on valuation, since the majority of OTC derivatives are collateralized. The model shows that a fully collateralized swap is risk-free, whereas a fully collateralized CDS is not equivalent to a risk-free one.

Subject Areas

asset pricing; credit risk modeling; unilateral; bilateral; multilateral credit risk; collateralization; comvariance; comrelation; correlation

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