The Implications of Dependence, Tail Dependence, and Bounds’ Measures for Counterparty Credit Risk
(Accepted for publication in "Journal of Financial Stability")
Abstract
This paper investigates the counterparty credit risk of interest rate swaps positions using the credit valuation
adjustment (CVA) measure, and examines the potential dependence relationships between the probability of
default (PD) and exposure at default (EAD). We empirically tested, using interest rate swaption implied
market volatilities, six tail dependence models: a Basel III Committee independent model, a Gaussian,
Student’s t, Gumbel, Clayton, and a wrong way risk (WWR) copula with dependence approach. The
results show that the CVA underestimation when using a Clayton copula for modelling the dependence of
PD and EAD is about 10%–856% compared to using WWR, and the underestimation between using the
standardised Basel independent model and using the Gaussian copula is about 552%–2621%, including the
period of the 2007/2008 crisis, signalling that dependence is more important than tail dependence for CVA
measurement. This has important implications for regulators, financial institutions, and credit risk managers
when calculating counterparty risk.
Keywords: Credit risk, Counterparty Credit Risk, Credit value adjustment, Dependence of credit risk
components, Pricing swaps
JEL Classification: G10, G13, G33.
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