Valuation and Hedging of CDS Counterparty Exposure in a Markov Copula Model
by Tomasz R. Bielecki of the Illinois Institute of Technology,
February 18, 2011
Abstract: A Markov model is constructed for studying the counterparty risk in a CDS contract. The 'wrong-way risk' in this model is accounted for by the possibility of the common default of the reference name and of the counterparty. A dynamic copula property as well as a ne model specifications make pricing and calibration very efficient. We also consider the issue of dynamically hedging the CVA with a rolling CDS written on the counterparty. Numerical results are presented to show the adequacy of the behavior of CVA in the model with stylized features.
Keywords: Counterparty Credit Risk, CDS, CVA, Wrong-Way Risk, Dynamic Hedging
Forthcoming in: International Journal of Theoretical and Applied Finance.