Dangers of Bilateral Counterparty Risk: the fundamental impact of closeout conventions

TL;DR

This paper investigates how different closeout conventions, especially substitution closeouts, significantly affect bilateral counterparty risk adjustments and potential default contagion, challenging previous assumptions of risk-free closeouts.

Contribution

It highlights the importance of closeout conventions in counterparty risk modeling, emphasizing the impact of substitution closeouts over risk-free assumptions and analyzing their effects under various default dependencies.

Findings

Substitution closeouts significantly alter risk adjustment calculations.

Default dependence models influence contagion risk outcomes.

Collateral presence modifies risk assessment dynamics.

Abstract

We analyze the practical consequences of the bilateral counterparty risk adjustment. We point out that past literature assumes that, at the moment of the first default, a risk-free closeout amount will be used. We argue that the legal (ISDA) documentation suggests in many points that a substitution closeout should be used. This would take into account the risk of default of the survived party. We show how the bilateral counterparty risk adjustment changes strongly when a substitution closeout amount is considered. We model the two extreme cases of default independence and co-monotonicity, which highlight pros and cons of both risk free and substitution closeout formulations, and allow us to interpret the outcomes as dramatic consequences on default contagion. Finally, we analyze the situation when collateral is present.