Valuation of Credit Derivatives with Counterparty Risk

The valuation of credit derivatives has for a long time been based on the assumption of default free counterparties. However, credit derivatives are not traded at an exchange and less than half of the OTC market participants are rated “A” or above. Hence, the consideration of counterparty risk is essential for a correct and consistent valuation of credit derivatives. Given this fact, the paper discusses the valuation of credit default swaps with defaultable counterparties. We address valuation based on observable market data (Hull and White 2000, 2001), Merton´s structural approach, a two-state-intensity model according to Jarrow and Yu (2001) and a rating-based approach following Lando (2000)