Pricing of counterparty credit risk in OTC derivatives
Authors: Arne Reichel (Goethe University), Florian Balke (Goethe University), Andreas Barth (Goethe University) and Mark Wahrenburg (Goethe University)
Title: Pricing of counterparty credit risk in OTC derivatives
Abstract: This paper documents how counterparty credit risk is priced in FX OTC derivatives. We employ a novel dataset of bank-specific bid-ask quotes and use the Swiss franc decoupling from the euro on January 15, 2015 as an exogenous event to describe two channels that affect counterparty risk. First, the exogenous increase in the EURCHF FX spot price volatility following the decoupling event translates into a widening in quoted bid-ask-spreads for CHF currency pairs in the FX swap market. Second, the large price movements in the EURCHF FX spot price following the decoupling announcement remembered markets of a potential jump risk for fixed currencies and thus, spilled-over to the pricing of other currencies with a fixed exchange rate regime. The second result finding implies that there was a central bank induced risk discount through credible currency pegs.