Capturing credit correlation between counterparty and underlying
Kirk Buckley, Sascha Wilkens and Vladimir Chorniy present a semi-analytical approach for calculating the counterparty exposure of credit derivatives contracts conditional on the default of the counterparty, based on a Merton-type asset return model. The approach provides an efficient algorithm for implementing large-scale exposure calculations for portfolios of credit derivatives
The conventional approach to calculating counterparty exposure assumes that the underlying of the derivative and the counterparty credit quality are uncorrelated. There are many cases, however, where this assumption does not necessarily hold. Examples of these cases include emerging market currencies, commodity producers hedging future production and credit derivatives. In this article, we focus on the case of credit derivatives where the underlying reference entities are correlated with the
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