The Implications of Tail Dependency Measures for Counterparty Credit Risk Pricing

Abstract

This paper investigates the counterparty credit risk of interest rate swaps positions using the credit valuation adjustment (CVA) measure, and examines the potential dependency relationships between the probability of default (PD) and exposure at default (EAD). We empirically tested, using interest rate swaption implied market volatilities, three tail dependency models: a Basel III Committee independent model, a Gaussian copula dependent model, and a Wrong Way Risk (WWR) with copula dependency approach. The results show that the CVA underestimation when using a Gaussian copula for modelling the dependence of PD and EAD is about 51%–362% compared to using WWR, and the underestimation between using the standardised Basel independent model and using the Gaussian copula is about 527%–1609%, including the period of the 2007/2008 crisis. This has important implications for regulators, financial institutions, and credit risk managers when calculating counterparty risk.