Pricing derivatives with counterparty risk and collateralization: a fixed point approach

DOI10.1016/J.EJOR.2015.06.055zbMATH Open1346.91234arXiv1501.06221OpenAlexW3121846808MaRDI QIDQ320989FDOQ320989

Authors: Jinbeom Kim, Tim Leung 

Publication date: 7 October 2016

Published in: European Journal of Operational Research (Search for Journal in Brave)

Abstract: This paper studies a valuation framework for financial contracts subject to reference and counterparty default risks with collateralization requirement. We propose a fixed point approach to analyze the mark-to-market contract value with counterparty risk provision, and show that it is a unique bounded and continuous fixed point via contraction mapping. This leads us to develop an accurate iterative numerical scheme for valuation. Specifically, we solve a sequence of linear inhomogeneous PDEs, whose solutions converge to the fixed point price function. We apply our methodology to compute the bid and ask prices for both defaultable equity and fixed-income derivatives, and illustrate the non-trivial effects of counterparty risk, collateralization ratio and liquidation convention on the bid-ask spreads.

Full work available at URL: https://arxiv.org/abs/1501.06221

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zbMATH Keywords

bilateral counterparty riskcollateralizationcredit valuation adjustmentfixed point method contraction mapping

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) PDEs in connection with game theory, economics, social and behavioral sciences (35Q91) Credit risk (91G40) Applications of stochastic analysis (to PDEs, etc.) (60H30) Financial applications of other theories (91G80)

Cites Work

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Cited In (12)

• Integrated structural approach to credit value adjustment
• Approximate value adjustments for European claims
• Affine term structure models: A time‐change approach with perfect fit to market curves
• MULTI-CURRENCY CREDIT DEFAULT SWAPS
• Disentangling wrong-way risk: pricing credit valuation adjustment via change of measures
• Analytical valuation of vulnerable European and Asian options in intensity-based models
• Pricing collateralized derivatives with an arbitrary numeraire
• Bilateral Credit Valuation Adjustment of CDS Under Systemic and Correlated Idiosyncratic Risks
• A BSDE with delayed generator approach to pricing under counterparty risk and collateralization
• Analysis of non-linear approximated value equation under multiple risk factors and stochastic intensities
• Pricing \(k\)th realization derivatives and collateralized debt obligation with multivariate Fréchet copula
• Nonlinear valuation under credit, funding, and margins: existence, uniqueness, invariance, and disentanglement

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