Why Bilateral Counterparty Risk Pricing Includes Own Default

Summary

The document explains why pricing counterparty credit risk bilaterally means considering both parties’ default risk. A unilateral model that accounts only for the other party’s chance of default can produce valuations that are harder for counterparties to reconcile, potentially preventing agreement on a trade.

The answer also points to two reasons to include a firm’s own default risk: its credit quality can be inferred from market prices such as credit default swaps and bonds, and default risk affects funding. The discussion is brief and conceptual; it gives no pricing formula, worked example, or evidence comparing alternative models. It also does not address how to estimate the adjustments or manage disagreements over model assumptions.

Key ideas

• Unilateral counterparty credit models can produce valuations that counterparties may struggle to agree on.
• A bilateral perspective includes the possibility that either party defaults.
• A party’s own credit risk can be reflected in market prices such as credit default swaps and bonds.
• Own default risk also matters because it affects funding.

Tags

# Bilateral Counterparty risk


# Bilateral Counterparty risk












Why do counterparty risk pricing adjustments need be considered in a bilateral counterparty risk perspective?

Thanks

## Answer by AFK (score 2, accepted)

https://quant.stackexchange.com/a/25110

If each party uses unilateral CCR model, i.e. Only takes into account the other party's probability of default, they are much less likely to agree on a price and actually trade.

In general, you want to take your own default into account simply because it is market observable through cds and bond spreads. And because it will affect your funding.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.