Default Dependency Impact

A broad range of financial instruments bear credit risk. Credit risk may be unilateral, bilateral, or multilateral. Some instruments such as, loans, bonds, etc, by nature contain only unilateral credit risk because only the default risk of one party appears to be relevant, whereas some other instruments, such as, over the counter (OTC) derivatives, securities financing transactions (SFT), and credit derivatives, bear bilateral or multilateral credit risk because two or more parties are susceptible to default risk. This paper mainly discusses bilateral and multilateral credit risk modeling, with a particular focus on default dependency, as correlated credit risk is one of the greatest threats to global financial markets.

There are two primary types of models that attempt to describe default processes in the literature: structural models and reduced-form (or intensity) models. Many practitioners in the credit trading arena have tended to gravitate toward the reduced-from models given their mathematical tractability. They can be made consistent with the risk-neutral probabilities of default backed out from corporate bond prices or credit default swap (CDS) spreads/premia.

This article presents a new valuation framework for pricing financial instruments subject to credit risk. In particular, we focus on modeling default relationships. Some well-known risky valuation models in the market can be viewed as special cases of this framework, when the default dependencies are ignored.

To capture the default relationships among more than two defaultable entities, we introduce a new statistic: comrelation, an analogue to correlation for multiple variables, to exploit any multivariate statistical relationship. Our research shows that accounting for default correlations and comrelations becomes important, especially under market stress. The existing valuation models in the credit derivatives market, which take into account only pair-wise default correlations, may underestimate credit risk and may be inappropriate.

We study the sensitivity of the price of a defaultable instrument to changes in the joint credit quality of the parties. For instance, our analysis shows that the effect of default dependence on CDS premia from large to small is the correlation between the protection seller and the reference entity, the comrelation, the correlation between the protection buyer and the reference entity, and the correlation between the protection buyer and the protection seller.

The model shows that a fully collateralized swap is risk-free, while a fully collateralized CDS is not equivalent to a risk-free one. Therefore, we conclude that collateralization designed to mitigate counterparty risk works well for financial instruments subject to bilateral credit risk, but fails for ones subject to multilateral credit risk.

• osf gic
• inarxiv Dependency
• Authorea dependency
• Authorea dependency latex
• Zenodo deferred
• GitBook Dependency PDF
• zenodo commitment
• Socraxiv dependency
• pubpub death put