RT Journal Article SR Electronic T1 Vulnerable Exotic Derivatives JF The Journal of Derivatives FD Institutional Investor Journals SP 84 OP 102 DO 10.3905/jod.2017.24.3.084 VO 24 IS 3 A1 Marcos Escobar A1 Mirco Mahlstedt A1 Sven Panz A1 Rudi Zagst YR 2017 UL https://pm-research.com/content/24/3/84.abstract AB Understanding and managing counterparty credit risk exposure in derivatives contracts has become a crucial element of real-world trading as well as theoretical modeling. But existing models are limited in the number of securities involved and in the assumed dynamics of the underlying asset returns processes. In this article, the authors present a framework with two counterparties who enter into a derivatives contract in which either of them may default, and the derivative’s payoff depends on the joint distribution of n different assets. Three specific examples illustrate application of the approach: an option on a security in which both counterparties are subject to default risk; a vulnerable spread option, in which one risky counterparty issues an option tied to the price spread between two other assets; and a defaultable swap with one underlying and two risky counterparties who commit to a series of future cash flows. The resulting pricing formulas are mathematically complicated, but as closed-form solutions (with the caveat that integral expressions are approximated using finite step size and number of terms in an infinite series), they are much more efficient than Monte Carlo simulation in reaching a given level of accuracy.TOPICS: Counterparty risk, quantitative methods, credit risk management