The Impact of Counterparty Risk on Credit Default Swap Pricing Dynamics

Abstract

As observed throughout the financial crisis in 2008 CDS contracts are not only exposed 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 is decreasing with a higher creditworthiness of the underlying reference entity. We show that counterparty risk has been incorporated in the CDS spreads for North American reference entities already 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 as compared to measures relying on the correlation structures of asset returns of reference entities and CDS counterparties.