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I'm looking to figure out how to price "insurance" against a counter-party defaulting in an OTC cryptocurrency transaction. I think the first measure would be to calculate VaR? I'm planning on modeling bitcoin using a stochastic process and calibrating it using historical data. I'm not quite sure which model to use for bitcoin. I've seen some papers use a GARCH model. In general, am I approaching this correctly? Any suggestions? Thanks!

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  • $\begingroup$ Can you give a little bit more detail of how the OTC product is structured? Is this cash settled or physical delivery? I don't think VaR is a bad way to model it but you need to be wary of the liquidity risk (hence why I ask if it is cash settled or physical delivery) $\endgroup$ – HK47 Aug 16 '18 at 14:29
  • $\begingroup$ It's physically settled. There is leverage involved so each counter-party only needs to provide initial margin. In case a counter-party becomes insolvent, there should be insurance purchased to cover the shortfall. I'm trying to price that insurance. $\endgroup$ – bloodynri Aug 16 '18 at 14:43
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    $\begingroup$ This sounds like a CDS contract. See if these are helpful: vlab.stern.nyu.edu/doc/25?topic=mdls and wwwf.imperial.ac.uk/~dbrigo/cdsmktfor.pdf My background is not in credit risk modeling so sorry if you are looking for something more detailed. $\endgroup$ – HK47 Aug 16 '18 at 15:18
  • $\begingroup$ This sounds like CVA (credit value adjustment) if not on a specific instrument $\endgroup$ – Kch Aug 17 '18 at 2:20
  • $\begingroup$ GARCH could serve as a building block but, by itself, it is too well-behaved. Not suitable for Bitcoin. At the very least, as a proxy for Bitcoin dynamics you should use jump-diffusion with stochastic volatility effects. Those volatility effects could be GARCH-inspired but that is not necessarily the best specification. $\endgroup$ – stans Aug 19 '18 at 17:02

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