Counterparty credit risk (CCR) refers to the risk that a counterparty will not pay up as obligated in a contract. Under such circumstances, an economic loss would occur if the transaction with the counterparty has a positive economic value at the time of default. In recent years, counterparty credit risk has become a prominent risk for market participants. One well-known example is the global financial crisis of 2007–2008, in which many financial institutions throughout the world suffered major and unexpected losses from mortgage-backed securities.

The effect of counterparty credit risk on derivative pricing has been widely covered in theoretical models where derivatives are known as vulnerable derivatives. The most recent literature has expanded into counterparty credit risk on other derivatives. That said, despite the importance of counterparty credit risk in financial markets, there are few empirical studies on its pricing in derivative securities. In fact, most studies have focused almost exclusively on the interest rate swap market, and have found that the effect of counterparty credit risk on the swap rate in interest rate swaps is extremely small.

One key reason for the limited roles of counterparty credit risk in determining the prices of derivative securities is related to the credit risk mitigating mechanisms required for over-the-counter transactions such as collateral and netting. In short, collateral partially reduces credit risk, and the netting mechanism ensures that all contracts between the counterparties are aggregated to give a net amount. According to Gang Li and Chu Zhang, “this mechanism reduces counterparty credit risk and makes the actual credit risk involved in the transactions difficult to measure.”

To obtain evidence for the effect of counterparty credit risk options on pricing, a study by Gang Li and Chu Zhang used derivative warrants and options data from the Hong Kong market. The researchers explain, “the call and put derivative warrants traded in Hong Kong resemble the usual call and put options traded in the US and elsewhere, except that they can be issued only by certain financial institutions approved by regulators.”

Notably, the derivative warrants and options in their sample were both traded on the Hong Kong Stock Exchange. According to the researchers, “derivative warrants are option-type derivatives, where the issuer assumes liability for the transaction.” As a result, this makes the impact of credit risk on pricing easier to detect, as opposed to forward-type derivatives (e.g., interest rate swaps and CDS), where counterparties might assume liability such that it cancels out to a large extent.

The empirical analyses of their study used a simple model containing a minimal parametric structure, yet was rich enough to yield qualitative implications that were suitable for empirical examination. “The empirical results of the research show that counterparty credit risk has a significant impact on the pricing of the derivative warrants, controlling for other factors that can affect warrant prices. The relation between the CDS spreads of issuers and the prices of derivative warrants is economically significant”, they explain.

Additionally, the authors found that, “when the underlying asset suffers a big loss, put options provide protection that is valuable, while call options are out of the money with limited value. If an issuer of warrants defaults with a higher probability when the underlying value declines, the protection that put warrants promise to offer becomes much less trustworthy, so its value declines.”