COUNTERPARTY CREDIT RISK AND THE CREDIT DEFAULT SWAP MARKET Navneet Arora Priyank Gandhi

Counterparty credit risk has become one of the highest-profile risks facing participants in the financial markets. Despite this, relatively little is known about how counterparty credit risk is actually priced. We examine this issue using an extensive proprietary data set of contemporaneous CDS transaction prices and quotes by 14 different CDS dealers selling credit protection on the same underlying firm. This unique cross-sectional data set allows us to identify directly how dealers’ credit risk affects the prices of these controversial credit derivatives. We find that counterparty credit risk is significantly priced in the CDS market. The magnitude of the effect, however, is relatively modest and is consistent with a market structure in which participants require collateralization of swap liabilities by counterparties. The pricing of counterparty credit risk became much more significant after the Lehman default at both the market level and at the level of individual CDS dealers. Furthermore, there is some evidence of strategic behavior by CDS dealers with the best credit. Surprisingly, we find that counterparty credit risk is not priced in the CDS spreads for financial firms in the sample, but is priced for the nonfinancial firms. This may suggest that the market expects large CDS dealers to be treated as too large to fail when other major financial firms begin to default. Current draft: January 2010. Navneet Arora is with Blackrock. Priyank Gandhi is with the UCLA Anderson School. Francis A. Longstaff is with the UCLA Anderson School and the NBER. The authors are grateful for helpful discussions with Peter Knez, Peter Meindl, Derek Schaeffer, and Victor Wong. All errors are our responsibility.