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=
}
(A3)
In these equations, T is the longest maturity of the derivatives in the portfolio, ) (t f
+
is the value
today of a derivative that pays off the dealers exposure to the counterparty at time t, ) (t f
is the
value today of a derivative that pays off the counterpartys exposure to the dealer at time t ,
( )
d
q t t A is the probability of the dealer defaulting between times t and t+At, and ( )
c
q t t A is the
probability of the counterparty defaulting between times t and t+At.
13
The variables ( )
d
R t and
( )
c
R t
are the dealers and the counterpartys expected recovery rate from a default at time t. The
amount claimed on an uncollateralized derivatives exposure in the event of a default is the no-
default value. The recovery rates, ( )
d
R t and ( )
c
R t , can therefore be more precisely defined as
the percentage of no-default value of the derivatives portfolio that is recovered in the event of a
default.
The probabilities
c
q and
d
q can be estimated from the credit spreads on bonds issued by the
counterparty and the dealer. A complication is that the claim in the event of a default for a
derivatives portfolio is in many jurisdictions different from that for a bond. The credit spreads on
bonds issued must be used in conjunction with claim procedures applicable to the bonds and
12
We assume that the recovery rate, default rate, and value of the derivative are mutually independent.
13
Some adjustment for the possibility that both parties will default during the life of the derivatives portfolio may be
necessary. See, for example, Brigo and Morini (2011).
21
their expected recovery rates to estimate default probabilities. Hull and White (2000) indicate
how these calculations can be carried out.
We define the adjusted borrowing rate of a company as the borrowing rate it would have if a
zero-coupon bond issued by the company were treated in the same way as derivatives in the
event of a default. We similarly define the adjusted credit spread of a zero-coupon bond issued
by a company as the credit spread it would have if it were treated in the same way as a derivative
in the event of a default. Once default probabilities have been estimated as just described, a term
structure of adjusted credit spreads for a company can be calculated.
For convenience, we define the loss rate for the dealer as ( ) ( )(1 ( ))
d d d
L t q t R t = and the loss rate
for the counterparty as ( ) ( )(1 ( ))
c c c
L t q t R t = so that equations (A1), (A2), and (A3) become
nd
0 0
( ) ( ) ( ) ( )
T T
d c
f f f t L t dt f t L t dt
+
= +
} }
(A4)
As a first application of equation (A4) suppose that the dealer has a portfolio consisting only of a
zero-coupon bond issued by the counterparty and promising a payoff of $1 at time T. The zero-
coupon is treated like a derivative in the event of a default. In this case, 0 ) ( =
t f and
nd
) ( f t f =
+
. Furthermore
( ) T T s f f
c
) ( exp
nd
=
where ) (t s
c
is the adjusted credit spread for a zero coupon bond with maturity t issued by the
counterparty. It follows that
( ) T T s dt t L
c
T
c
) ( exp ) ( 1
0
=
}
(A5)
and
) ) ( exp( ) ) ( exp( ) (
2 2 1 1
2
1
t t s t t s dt t L
c
t
t
c c
=
}
(A6)
22
Similarly when the portfolio consists of a zero-coupon bond issued by the dealer,
nd
) ( f t f =
,
0 ) ( =
+
t f and
( ) T T s f f
d
) ( exp
nd
=
where ) (t s
d
is the adjusted credit spread for a zero coupon bond with maturity t issued by the
dealer. It follows that
( ) T T s dt t L
d
T
d
) ( exp ) ( 1
0
=
}
(A7)
and
) ) ( exp( ) ) ( exp( ) (
2 2 1 1
2
1
t t s t t s dt t L
c
t
t
c c
=
}
(A8)
There are three special cases where it is possible to use the discount rate to adjust for default risk
1. The portfolio promises a single positive payoff to the dealer (and negative payoff to the
counterparty) at time T. In this case 0 ) ( =
t f and
nd
) ( f t f =
+
so that from equation
(A4)
(
=
}
T
c
dt t L f f
0
nd
) ( 1
Using equation (A5) we obtain
( ) T T s f f
c
) ( exp
nd
=
This result shows that the derivative can be valued by using a discount rate equal to the
risk-free rate for maturity T plus s
c
(T).
2. The portfolio promises a single negative value to the dealer (and positive value to the
counterparty) at time T. In this case
nd
) ( f t f =
and 0 ) ( =
+
t f so that
23
(
=
}
T
d
dt t L f f
0
nd
) ( 1
Using equation (A7) we obtain
( ) T T s f f
d
) ( exp
nd
=
This result shows that the derivative can be valued by using a discount rate equal to the
risk-free rate for maturity T plus s
d
(T).
3. The derivatives portfolio promises a single payoff, which can be positive or negative at
time T, and the two sides have identical loss rates: L
c
(t) = L
d
(t) = L(t) for all t.
Because
nd
) ( f t f f =
+
equation (4) becomes
(
=
}
T
dt t L f f
0
nd
) ( 1
From equation (A5) or (A7) we obtain
( ) T T s f f ) ( exp
nd
=
where s(T) is the common adjusted credit spread for the dealer and the counterparty. This
result shows that the derivative can be valued by using a discount rate equal to the risk-
free rate for maturity T plus s(T).
These three cases can be generalized. A derivative promising positive payoffs to the dealer at
several different times is the sum of derivatives similar to those in 1 and can be valued using
discount rates that reflect the counterpartys adjusted borrowing rates. Similarly, a derivative
promising payoffs negative payoffs to the dealer at several different times is the sum of
derivatives similar to those in 2 and can be valued using discount rates that reflect the dealers
adjusted borrowing rates. Finally, Case 3 shows that when the two sides have identical credit
risks, any derivative can be valued by using discount rates that reflect their common adjusted
borrowing rates.
24
We now return to considering the general situation. We define ( ) L t as the loss rate at time t for
a company whose adjusted credit spread is the LIBOR-OIS credit spread. This means that,
similarly to equations (A5) to (A8)
( ) T T s dt t L
T
) ( exp ) ( 1
0
=
}
(A9)
and
) ) ( exp( ) ) ( exp( ) (
2 2 1 1
2
1
t t s t t s dt t L
t
t
=
}
(A10)
where ) (t s