Counterparty default risk. Because derivative instruments are contracts in which the parties agree on future cashflows according to predefined rules, parties which are to receive cash-flows are exposed to credit risk if it is conceivable that the counterparty will not or cannot satisfy its contractual obligations in the future. As a consequence, the fair price of a vulnerable derivative differs from the default-free price.
Options on credit-risky bonds. Credit risk results in lower prices for credit-risky bonds. However, the price distribution does not simply move, it also changes shape because of the low-probability, high-loss property of default risk. Accordingly, options on risky bonds cannot be priced with standard option pricing methods but require a credit risk model.
Credit derivatives. Credit risk may be the underlying variable of derivative contracts. In this case credit risk is not a byproduct of a derivative, but the purpose of the contract itself.
Credit derivatives with counterparty default risk. As typical OTC derivative contracts, credit derivatives themselves are subject to counterparty risk. In this case, two distinct forms of credit risk affect the price of the credit derivative. On the one hand, the promised payoff of the contract is calculated based on a credit risk variable, such as a credit spread or a default loss caused by the default of the party specified in the contract. On the other hand, the counterparty risk of the derivative counterparty can affect the value of the contract.
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