Table 1. Payoffs of a bilaterally defaultable contract
This table displays all possible payoffs at time T . In the case of , there are a total of four possible states at time T: i) BothA and B survive with probability . The contract value is equal to the payoff . ii) A defaults but B survives with probability. The contract value is , where represents the non-default recovery rate11There are two default settlement rules in the market. The one-way payment rule was specified by the early ISDA master agreement. The non-defaulting party is not obligated to compensate the defaulting party if the remaining market value of the instrument is positive for the defaulting party. The two-way payment rule is based on current ISDA documentation. The non-defaulting party will pay the full market value of the instrument to the defaulting party if the contract has positive value to the defaulting party.. =0 represents the one-way settlement rule, while =1 represents the two-way settlement rule. iii) A survives butB defaults with probability . The contract value is , where represents the default recovery rate. iv) Both A and Bdefault with probability . The contract value is , where denotes the joint recovery rate when both parties A and B default simultaneously. A similar logic applies to the case of .