Counterparty credit risk and the credit default swap market

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS tran...

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Bibliographic Details
Published in:Journal of financial economics 2012-02, Vol.103 (2), p.280-293
Main Authors: Arora, Navneet, Gandhi, Priyank, Longstaff, Francis A.
Format: Article
Language:English
Subjects:
Capital market
Collateralization
Counterparty credit risk
Credit
Credit default swaps
Credit risk
Financial economics
Market structure
Risk
Securities prices
Studies
Transaction costs
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Summary:Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers' credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is priced in the CDS market. The magnitude of the effect, however, is vanishingly small and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2011.10.001