Baeho Kim

Baeho Kim, Korea University Business School

Stochastic Intensity Margin Modeling of Credit Default Swap Portfolios

Central counterparties (CCPs) estimate the initial margin (IM) of their members' credit default swap (CDS) portfolios by statistically modeling CDS spreads. There are shortcomings in the way CCPs convert spreads to CDS prices. It is well-known that valuation of a CDS contract requires a model for default timing of the reference entity. This is absent from risk management practices at clearinghouses. Inconsistencies in converting spreads to prices can turn into inconsistent IM estimates. Using the reduced-form approach, we introduce a stochastic intensity IM model of CDS portfolios and calibrate it to market-observed spreads using an approximate maximum likelihood estimation procedure. We show that CCPs' margin estimates can substantially differ from those produced by the reduced-form model. Lack of consistency and transparency in IM calls may increase systemic risk in OTC derivatives markets.