Title: A Dynamic Model of Central Counterparty Risk,
Abstract: We introduce a dynamic model of the default waterfall of derivatives CCPs and
propose a risk sensitive method for sizing the initial margin (IM), and the
default fund (DF) and its allocation among clearing members. Using a Markovian
structure model of joint credit migrations, our evaluation of DF takes into
account the joint credit quality of clearing members as they evolve over time.
Another important aspect of the proposed methodology is the use of the time
consistent dynamic risk measures for computation of IM and DF. We carry out a
comprehensive numerical study, where, in particular, we analyze the advantages
of the proposed methodology and its comparison with the currently prevailing
methods used in industry.