VALUATION AND HEDGING OF CDS COUNTERPARTY EXPOSURE IN A MARKOV COPULA MODEL

TLDR

The study develops a Markov model to analyze counterparty risk in CDS contracts and investigates dynamic hedging of CVA using a rolling counterparty CDS. The model incorporates wrong‑way risk through joint default of reference and counterparty, employs a dynamic copula with affine specifications for efficient pricing and calibration, and supports dynamic CVA hedging. Numerical experiments show that the dynamic copula‑affine framework yields efficient pricing and accurately captures CVA behavior under stylized scenarios.

Abstract

A Markov model is constructed for studying the counterparty risk in a CDS contract. The "wrong-way risk" in this model is accounted for by the possibility of the common default of the reference name and of the counterparty. A dynamic copula property as well as affine model specifications make pricing and calibration very efficient. We also consider the issue of dynamically hedging the CVA with a rolling CDS written on the counterparty. Numerical results are presented to show the adequacy of the behavior of CVA in the model with stylized features.