Revisiting Interest Rate Swap Valuation with Counterparty Risk, Wrong-Way Risk and OIS Discount

This paper extends extant valuation models of interest rate swaps (IRS) with counterparty credit risk by accounting for wrong-way risk and OIS discounting. The proposed model extends Brigo and Pallavicini's (2007) and Ruiz et al.'s (2013) models, by capturing wrong-way risk in the CVA calculation by way of the correlation between the intensity of default of the counterparty and the market interest rate. Under the proposed no-arbitrage pricing model, cash flows are discounted using the OIS rates (mostly used by market practitioners following the 2007-2009 credit crisis), a proxy for risk-free rates. We therefore propose a unified framework that captures under one umbrella: CVA, wrong-way risk, and OIS discounting. The model parameters are estimated using real market data. Our findings indicate that it is important to account for both counterparty and wrong-way risk in IRS valuation since the two phenomena have non-negligible impacts on the CVA value. Also, using the OIS rates as risk-free discount rates, our model yields adjustment values higher than those obtained with the traditional Libor discount rates