2010/11/15 by Damiano Brigo, Brigo, Damiano, Massimo Morini +1
Economics, Econometrics and Finance · #62H20 #91B70 #Banking stability, regulation, efficiency #Credit Risk and Financial Regulations #Economic Policies and Impacts #FOS: Economics and business #Insurance and Financial Risk Management #Pricing of Securities (q-fin.PR) #msc:62H20 #msc:91B70 #q-fin.PR
paper · pdf · doi:10.48550/arxiv.1011.3355
arxiv created 2010/11/15 · openalex publication_date 2010/11/15 · arxiv updated 2010/11/16 · openalex created_date 2022/10/03 · openalex updated_date 2026/07/28
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.