Title: An equilibrium model for the OTC derivative with the counterparty risk via the credit charge

Authors: Kazuhiro Takino

Addresses: Faculty of Commerce, Nagoya University of Commerce and Business, 4-4 Sagamine, Komenoki-Cho, Nisshin, Aichi 470-0193, Japan

Abstract: In this article, we propose an equilibrium model for the OTC derivative market with the counterparty risk. We consider an incomplete market model and apply the utility-based pricing. These lead to the demand function and supply function for the claim, and enables us to gain the equilibrium volume/price for it. We set up two approaches to incorporate the counterparty risk into the pricing formula. The one is the pricing model with the credit charge and the other is with the credit risk model. The latter especially corresponds to a traditional pricing method for the defaultable claim. We then demonstrate the influence of the counterparty risk on the equilibrium price, volume, and the market size for both approaches. Our results verify the role of the credit charge in the OTC derivatives market, that is, the credit charge has a possibility to recover the liquidity and the market size.

Keywords: OTC derivatives markets; over-the-counter derivatives; counterparty risk; incomplete market; credit charge; utility-based pricing; market equilibrium; credit risk; modelling; equilibrium price; volume; market size; liquidity.

DOI: 10.1504/IJFMD.2015.069979

International Journal of Financial Markets and Derivatives, 2015 Vol.4 No.2, pp.97 - 121

Available online: 19 Jun 2015 *

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