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In Rememberance: World Trade Center (WTC)

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Valuation and Hedging of CDS Counterparty Exposure in a Markov Copula Model

by Tomasz R. Bielecki of the Illinois Institute of Technology,
Stéphane Crépey of the Université d'Évry Val d'Essonne,
Monique Jeanblanc of the Université d'Évry Val d'Essonne & Europlace Institute of Finance, and
Behnaz Zargari of the Université d'Évry Val d'Essonne & Sharif University 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.

JEL Classification: C02.

AMS Classification: 91B70, 91G40.

Keywords: Counterparty Credit Risk, CDS, CVA, Wrong-Way Risk, Dynamic Hedging

Forthcoming in: International Journal of Theoretical and Applied Finance.

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