Valuation of Interest Rate Swaps in the presence of Counterparty Credit Risk

Abstract: Insuring debt through credit default swaps (CDS) and collateralized debt obligations (CDO) has become increasingly more popular. Recent events such as the financial crisis of 2008 have shown that the credit models for these insurances have lacked severely in certain aspects. One commonly referred example of these ramifications that have ensued is the AIG, the largest insurance company in the United States, that were put into a serious liquidity crisis back in 2008 which prompted a large bailout by the U.S. government. The AIG incident made it evident that the instruments being used didn’t properly address a part of the credit exposure that is known as counterparty risk. Counterparty risk means the risk that the counterparty (in this case the insurance company) fails to meet its contractual obligations. Several models that account for this type of risk have been introduced during the past two decades. The purpose of this thesis is to explore this idea of accounting for counter party risk in financial derivatives and how it affects the pricing adjustment of interest rate swaps. We estimate the value of IRS agreements in the presence of counterparty risk by adding a credit value adjustment that is estimated using an intensity based approach. The intensity is assumed to be piecewise constant and is calibrated against observed market CDS–quotes using the bootstrapping method. We find that a 5–year IRS with a low–risk counterparty with 95.4% survival probability during this period yields a credit adjustment of about 40 basis points whereas a 30–year IRS with a high–risk counterparty with 13.5% survival probability yields a credit value adjustment of almost 1000 basis points.