Revisiting Interest Rate Swap Valuation with Counterparty Risk, Wrong-Way Risk, and OIS Discounting

Abstract

This article extends extant valuation models of interest rate swaps with counterparty credit risk by accounting for wrong-way risk and overnight index swap (OIS) discounting. The proposed model extends the models of previous researchers by capturing wrong-way risk in the credit value adjustment (CVA) calculation by way of the correlation between the intensity of default of the counterparty and the market interest rate. Under the proposed no-arbitrage pricing model, cash flows are discounted using OIS rates (mostly used by market practitioners following the 2007–2009 credit crisis), a proxy for risk-free rates. The authors thus propose a unified framework that captures under one umbrella: CVA, wrong-way risk, and OIS discounting. The model parameters are estimated using real market data. Their findings indicate that it is important to account for both counterparty and wrong-way risk in interest rate swap valuation since the two phenomena have nonnegligible impacts on CVA value. Additionally, using OIS rates as risk-free discount rates, the model yields adjustment values higher than those obtained with traditional LIBOR discount rates.