Dangers Of Bilateral Counterparty Risk: The Fundamental Impact Of Closeout Conventions
The authors analyze the practical consequences of the bilateral counterparty risk adjustment. They point out that past literature assumes that, at the moment of the first default, a risk-free closeout amount will be used. They argue that the legal (ISDA) documentation suggests in many points that a substitution closeout should be used. This would take into account the risk of default of the survived party. They show how the bilateral counterparty risk adjustment changes strongly when a substitution closeout amount is considered.