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  1.  59
    An Accurate Solution for Credit Valuation Adjustment (CVA) and Wrong Way Risk.Tim Xiao - 2015 - Journal of Fixed Incom 25 (1):84-95.
    This paper presents a Least Square Monte Carlo approach for accurately calculating credit value adjustment (CVA). In contrast to previous studies, the model relies on the probability distribution of a default time/jump rather than the default time itself, as the default time is usually inaccessible. As such, the model can achieve a high order of accuracy with a relatively easy implementation. We find that the valuation of a defaultable derivative is normally determined via backward induction when their payoffs could be (...)
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  2.  15
    The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling.Tim Xiao - manuscript
    This article presents a comprehensive framework for valuing financial instruments subject to credit risk. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats in financial markets. We analyze how swap rates are affected by bilateral counterparty credit risk, and how CDS spreads depend on the trilateral credit risk of the buyer, seller, and reference entity in a contract. Moreover, we study the effect of collateralization on (...)
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  3.  14
    Bilateral Defaultable Financial Derivatives Pricing and Credit Valuation Adjustment.Tim Xiao - manuscript
    The one-side defaultable financial derivatives valuation problems have been studied extensively, but the valuation of bilateral derivatives with asymmetric credit qualities is still lacking convincing mechanism. This paper presents an analytical model for valuing derivatives subject to default by both counterparties. The default-free interest rates are modeled by the Market Models, while the default time is modeled by the reduced-form model as the first jump of a time-inhomogeneous Poisson process. All quantities modeled are market-observable. The closed-form solution gives us a (...)
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  4.  14
    Incremental Risk Charge Methodology.Tim Xiao - manuscript
    The incremental risk charge (IRC) is a new regulatory requirement from the Basel Committee in response to the recent financial crisis. Notably few models for IRC have been developed in the literature. This paper proposes a methodology consisting of two Monte Carlo simulations. The first Monte Carlo simulation simulates default, migration, and concentration in an integrated way. Combining with full re-valuation, the loss distribution at the first liquidity horizon for a subportfolio can be generated. The second Monte Carlo simulation is (...)
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  5.  14
    An Economic Examination of Collateralization in Different Financial Markets.Tim Xiao - manuscript
    This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean (...)
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  6.  13
    Pricing Financial Derivatives Subject to Multilateral Credit Risk and Collateralization.Tim Xiao - manuscript
    This article presents a new model for valuing financial contracts subject to credit risk and collateralization. Examples include the valuation of a credit default swap (CDS) contract that is affected by the trilateral credit risk of the buyer, seller and reference entity. We show that default dependency has a significant impact on asset pricing. In fact, correlated default risk is one of the most pervasive threats in financial markets. We also show that a fully collateralized CDS is not equivalent to (...)
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  7.  27
    A Simple and Precise Method for Pricing Convertible Bond with Credit Risk.Tim Xiao - 2013 - Journal of Derivatives and Hedge Funds 19 (4):259-277.
    This paper presents a new model for valuing hybrid defaultable financial instruments, such as, convertible bonds. In contrast to previous studies, the model relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence (...)
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  8.  23
    A New Model for Pricing Collateralized Financial Derivatives.Tim Xiao - 2017 - Journal of Derivatives 24 (4):8-20.
    This paper presents a new model for pricing OTC derivatives subject to collateralization. It allows for collateral posting adhering to bankruptcy laws. As such, the model can back out the market price of a collateralized contract. This framework is very useful for valuing outstanding derivatives. Using a unique dataset, we find empirical evidence that credit risk alone is not overly important in determining credit-related spreads. Only accounting for both collateral arrangement and credit risk can sufficiently explain unsecured credit costs. This (...)
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  9.  11
    The Valuation of Interest Rate Swap with Bilateral Counterparty Risk.Tim Xiao - manuscript
    This paper presents an analytical model for valuing interest rate swaps, subject to bilateral counterparty credit risk. The counterparty defaults are modeled by the reduced-form model as the first jump of a time-inhomogeneous Poisson process. All quantities modeled are market-observable. The closed-form solution gives us a better understanding of the impact of the credit asymmetry on swap value, credit value adjustment, swap rate and swap spread.
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  10.  17
    Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds.Tim Xiao - 2015 - International Journal of Financial Markets and Derivatives 4 (1):1-25.
    This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due (...)
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  11.  8
    The Valuation of Credit Default Swap with Counterparty Risk and Collateralization.Tim Xiao - manuscript
    This article presents a new model for valuing a credit default swap (CDS) contract that is affected by multiple credit risks of the buyer, seller and reference entity. We show that default dependency has a significant impact on asset pricing. In fact, correlated default risk is one of the most pervasive threats in financial markets. We also show that a fully collateralized CDS is not equivalent to a risk-free one. In other words, full collateralization cannot eliminate counterparty risk completely in (...)
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  12.  8
    The Valuation of Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment.Tim Xiao - manuscript
    This article presents a generic model for pricing financial derivatives subject to counterparty credit risk. Both unilateral and bilateral types of credit risks are considered. Our study shows that credit risk should be modeled as American style options in most cases, which require a backward induction valuation. To correct a common mistake in the literature, we emphasize that the market value of a defaultable derivative is actually a risky value rather than a risk-free value. Credit value adjustment (CVA) is also (...)
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  13.  15
    An Efficient Lattice Algorithm for the Libor Market Model.Tim Xiao - 2011 - Journal of Derivatives 19 (1):25-40.
    The LIBOR Market Model has become one of the most popular models for pricing interest rate products. It is commonly believed that Monte-Carlo simulation is the only viable method available for the LIBOR Market Model. In this article, however, we propose a lattice approach to price interest rate products within the LIBOR Market Model by introducing a shifted forward measure and several novel fast drift approximation methods. This model should achieve the best performance without losing much accuracy. Moreover, the calibration (...)
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