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The Journal of Derivatives

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The Impact of Margin Interest on the Valuation
of Credit Default Swaps

Yu Hang Kan and Claus Pedersen
The Journal of Derivatives Fall 2012, 20 (1) 60-79; DOI: https://doi.org/10.3905/jod.2012.20.1.060
Yu Hang Kan
is an assistant vice president at Barclays in Singapore.
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  • For correspondence: gabriel.kan@barclays.com
Claus Pedersen
is a director at Barclays in New York, NY.
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  • For correspondence: claus.pedersen@barclays.com
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Abstract

These days, both exchange-traded and most OTC derivatives transactions are collateralized: The upfront payment, if any, and regular mark-to-market variation margin are held in escrow, possibly earning interest, until the contract is exercised. In theoretical modeling, interest paid on the collateral is typically ignored, under the assumption that the mark-tomarket cash flows can go either way and, in any case, the interest amounts are small. Kan and Pedersen demonstrate that this intuition is not necessarily true. For credit default swaps (CDS), the impact of margin interest can be significant; in fact, the margin interest rate should be used for discounting in calculating the fair value of CDS.

TOPICS: Credit default swaps, accounting and ratio analysis, exchange-traded funds and applications

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The Journal of Derivatives: 20 (1)
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The Impact of Margin Interest on the Valuation
of Credit Default Swaps
Yu Hang Kan, Claus Pedersen
The Journal of Derivatives Aug 2012, 20 (1) 60-79; DOI: 10.3905/jod.2012.20.1.060

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The Impact of Margin Interest on the Valuation
of Credit Default Swaps
Yu Hang Kan, Claus Pedersen
The Journal of Derivatives Aug 2012, 20 (1) 60-79; DOI: 10.3905/jod.2012.20.1.060
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  • Article
    • Abstract
    • DISCRETE TIME
    • THE RISK-NEUTRAL PRICING APPROACH
    • ARBITRAGE OPPORTUNITIES FROM MISPRICING
    • THE REPLICATION APPROACH
    • COUNTERPARTY CREDIT RISK
    • EMPIRICAL STUDY
    • CONCLUSION
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