Pricing Credit Default Swap Subject to Counterparty Risk and Collateralization

TL;DR

This paper introduces a new model for valuing credit default swaps considering multiple credit risks and collateralization, highlighting the impact of default dependency and the limitations of collateralization in eliminating counterparty risk.

Contribution

It presents a novel valuation model for CDS that accounts for multiple credit risks and demonstrates that full collateralization does not fully eliminate counterparty risk.

Findings

Default dependency significantly affects asset pricing.

Fully collateralized CDSs are not equivalent to risk-free ones.

Correlated default risk is a pervasive market threat.

Abstract

This article presents a new model for valuing a credit default swap (CDS) contract that is affected by multiple credit risks of the buyer, seller and reference entity. We show that default dependency has a significant impact on asset pricing. In fact, correlated default risk is one of the most pervasive threats in financial markets. We also show that a fully collateralized CDS is not equivalent to a risk-free one. In other words, full collateralization cannot eliminate counterparty risk completely in the CDS market.