Single name LCDS Pricing and Related CVA Calculation regarding Counterparty Default

Abstract:

In this paper, under the reduced form framework, a pricing model for loan-only credit default swap (LCDS) with negative correlation between prepayment and default is established. Under reduced framework, by one factor inverse CIR model, we obtain a closed form pricing formula. Using this formula, a calculation scheme for credit value adjustment (CVA) for LCDS is given, where the counterparty risk of the LCDS is considered. Moreover, a wrong way risk related issue is discussed. The research conducted in this article indicates that the price of an LCDS contract with counterparty credit risk (CCR) is lower than one without CCR, and CVA increases with the termination of the LCDS, interest rate and the correlation between the reference loan and the counterparty. The spread for an LCDS with CCR is lower than that of a normal LCDS. If the reference loan is negatively correlated with the counterparty, CVA decreases with the absolute value of the correlation coefficient.