2014•International Journal of Theoretical and Applied FinanceRequires access

CONTAGION EFFECTS AND COLLATERALIZED CREDIT VALUE ADJUSTMENTS FOR CREDIT DEFAULT SWAPS

Rüdiger Frey, Lars Rösler

Abstract

The paper is concerned with counterparty credit risk for credit default swaps in the presence of default contagion. In particular, we study the impact of default contagion on credit value adjustments such as the Bilateral Collateralized Credit Value Adjustment (BCCVA) of Brigo et al. (2014) and on the performance of various collateralization strategies. We use the incomplete-information model of Frey & Schmidt (2012) for our analysis. We find that contagion effects have a substantial impact on the effectiveness of popular collateralization strategies. We go on and derive improved collateralization strategies that account for contagion. Theoretical results are complemented by a simulation study.

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Key concepts: Collateralization, Collateralized debt obligation, Credit default swap, iTraxx, Credit derivative, Credit risk, Credit valuation adjustment, Credit default swap index