Pricing credit default swaps with bilateral value adjustments

TL;DR

This paper extends a structural default model to analyze bilateral counterparty risk in credit default swaps, developing semi-analytical methods to evaluate significant credit and debt value adjustments in realistic scenarios.

Contribution

It introduces a three-dimensional structural default model with correlated firms' values and develops semi-analytical methods for calibration and pricing of bilateral counterparty risk.

Findings

Value adjustments can be surprisingly large in realistic cases

Semi-analytical methods effectively solve calibration and pricing problems

Model captures complex interactions in bilateral credit risk

Abstract

A three-dimensional extension of the structural default model with firms' values driven by correlated diffusion processes is presented. Green's function based semi-analytical methods for solving the forward calibration problem and backward pricing problem are developed. These methods are used to analyze bilateral counterparty risk for credit default swaps and evaluate the corresponding credit and debt value adjustments. It is shown that in many realistic cases these value adjustments can be surprisingly large.