Counterparty Credit Risk on a Standard Swap in “Risky Closeout”

Wei Wei

doi:10.5430/ijfr.v2n2p40

Abstract

This paper provides risky closeout amount in computing counterparty credit risk. Under this closeout, we obtain a new nonlinear PDE model describing the value of a standard interest swap with counterparty credit risk in the reduced form framework, thus get a new method to calculate counterparty credit valuation adjustment. We solve the nonlinear PDE by iterations numerically and prove the convergence of this approach. By numerical examples, we show the difference between risky closeout and conventional closeout in estimating counterparty credit risk.

Highlights

This paper provides risky closeout amount in computing counterparty credit risk
We expect that the risky closeout will be more accurate in calculating counterparty credit valuation adjustment (CVA)—the measurement of counterparty credit risk (CCR)
To show how to estimate CCR in risky closeout, we focus on a standard interest swap with CCR

Summary

Introduction

“The counterparty credit risk (CCR) is defined as the risk that the counterparty to a transaction could default before the final settlement of the transaction’s cash flow. Different from a risk free one, the risky closeout in computation is more complicated, but more consistent with the definition of CCR. We expect that the risky closeout will be more accurate in calculating counterparty credit valuation adjustment (CVA)—the measurement of CCR. To support this statement, we look back to the definition of CCR, which implies when the counterparty defaults, there will be no effect on the investor if the value of the transaction to the investor’s position is negative.

Cash flows

Reduced form models

Conclusions