The Counterparty Credit Risk of CDS Based on Information Game Model

Abstract

Counter party credit risk of the financial derivatives transaction is the risk that one party has a default before the expiration of the contract. This research investigates the unilateral counter party credit risk of credit default swap (CDS). Under different assumptions, three different information models are built. They are, the basic model with no counter party credit risk, the model considering unilateral counter party risk, and the model considering unilateral counter party risk as well as the collateral. Through comparing and analyzing these models, the conclusion is: considering counter party credit risk in the transaction process facilitates trading in a cautious manner, nevertheless, because of the assessment accuracy issue for the counter party credit risk, the success of such transactions may result in concentration of risk in the market, the collateral factors can increase the expected income and consequently promote the transactions. However, since it may be insufficient to eliminate counter party credit risk through the collateral, investors may still suffer from unexpected losses. In the end, the development of the CDS market before and after the financial crisis from the perspective of the counter party credit risk is analyzed.