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Dangers of Bilateral Counterparty Risk: The fundamental impact of closeout conventions

by Damiano Brigo of the King's College, London, and
Massimo Morini of the Banca IMI

November 16, 2010

Abstract: We analyze the practical consequences of the bilateral counterparty risk adjustment. We point out that past literature assumes that, at the moment of the first default, a risk-free closeout amount will be used. We argue that the legal (ISDA) documentation suggests in many points that a substitution closeout should be used. This would take into account the risk of default of the survived party. We show how the bilateral counterparty risk adjustment changes strongly when a substitution closeout amount is considered. We model the two extreme cases of default independence and co-monotonicity, which highlight pros and cons of both risk free and substitution closeout formulations, and allow us to interpret the outcomes as dramatic consequences on default contagion. Finally, we analyze the situation when collateral is present.

JEL Classification: G12, G13.

AMS Classification: 62H20, 91B70.

Keywords: Bilateral Counterparty Risk, Credit Valuation Adjustment, Debit Valuation Adjustment, Closeout, Default Contagion, Bond Pricing, Default Correlation, Co-monotonic Defaults, Collateral Modeling

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