Journal of Credit Risk

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The impact of counterparty risk on credit default swap pricing dynamics

Stefan Morkoetter, Johanna Pleus and Simone Westerfeld

ABSTRACT

As observed throughout the financial crisis in 2008, credit default swaps (CDSs) are exposed not only to the credit risk of the underlying reference entity but also to the counterparty risk of the protection seller. Conducting a panel regression analysis based on CDS contracts from 2004 to 2009 in Europe and North America for 198 reference entities, we find that market-oriented counterparty risk measures are reflected in the pricing of CDS contracts. The impact of counterparty risk decreases when increased creditworthiness of the underlying reference entity occurs. We show that counterparty risk had already been incorporated in the CDS spreads for North American reference entities prior to the financial crisis, whereas, for European reference entities, the pricing impact only intensified with the outbreak of the financial crisis in September 2008. Market-based counterparty risk measures have a higher impact on the pricing of CDS contracts compared with measures that rely on the correlation structures of asset returns of reference entities and CDS counterparties.