& Valuation of Credit Derivatives with Counterparty Risk

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2.1 INTRODUCTION The valuation of credit derivatives has for a long time been based on default-free counterparties (i.e., contractual partners), as this allows a risk-free valuation of the payments made under credit derivatives. Even though financial institutions own subsidiaries, which could act as counterparties in OTC derivatives (over-the-counter derivatives), and reach strong ratings of ‘‘AAA’’, Ammann (2001) shows that less than half of the market participants have a rating of ‘‘A’’ or above. Moreover, no exchange traded credit derivatives exist up to now. Following these arguments, the consideration of counterparty risk is essential for a correct and consistent valuation of credit derivatives.