Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

Abstract

We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

Market‐based estimates of implicit government guarantees in European financial institutions

“…The more interesting and relevant finding of Arora et al ( ) is that counterparty risk is not priced at all for financial firms, which are the subjects of this paper. A later study of Du, Gadgil, Gordy, and Vega ( ) largely confirms the conclusion of Arora et al ( ) and argues that counterparty risk is managed via the choice of counterparties…”

“…The more interesting and relevant finding of Arora et al (2012) is that counterparty risk is not priced at all for financial firms, which are the subjects of this paper. A later study of Du, Gadgil, Gordy, and Vega (2015) largely confirms the conclusion of Arora The assumption of identical risk-neutral PD is also made implicitly by Norden and Weber (2012) in calculating timevarying PD and LGD simultaneously with senior and subordinated CDS spreads. This is also consistent with the pricing model in Longstaff and Schwartz (1995), who assume the same risk-neutral PD for a firm's debts with different levels of seniority.…”

Managing Counterparty Risk in OTC Markets

“…Our model implication that high-risk banks engage in imperfect risk sharing is supported by empirical evidence provided by Du et al (2016). They develop a statistical multinomial logit model for the counterparty choice of buyers in the CDS market.…”

Loss Sharing in Central Clearinghouses: Winners and Losers

“…Empirical evidence on the impact of central clearing on derivative markets has been growing only recently, fueled by the increasing availability of granular data. Recent examples are Loon and Zhong (2014), Duffie et al (2015), Du et al (2016), andBellia et al (2019) for single-name CDS, Menkveld et al (2015) for equity, Mancini et al (2016) for interbank repo, and Cenedese et al (2020) and Dalla Fontana et al (2019) for IRS markets. Boissel et al (2017) estimate that prices in the European repo market implied a substantial risk of CCP failure during the 2011 European sovereign debt crisis.…”