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Credit Default Swap Valuation with Counterparty Risk

by Seng Yuen Leung of HSBC, and
Yue Kuen Kwok of the Hong Kong University of Science and Technology

June 2005

Abstract: Using the reduced form framework with inter-dependent default correlation, we perform valuation of credit default swap with counterparty risk. The inter-dependent default risk structure between the protection buyer, protection seller and the reference entity in the credit default swap are characterized by their correlated default intensities, where the default intensity of one party increases when the default of another party occurs. We explore how settlement risk and replacement cost affect the swap rate in credit default swaps.

JEL Classification: G12, G13.

Keywords: Counterparty risk, contagious defaults, intensity model, credit default swap.

Published in: Kyoto Economic Review, Vol. 74, No. 1, (June 2005), pp. 25-45.

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