The Valuation of Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment

Xiao, Tim (2019): The Valuation of Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment.

Abstract

This article presents a generic model for pricing financial derivatives subject to counterparty credit risk. Both unilateral and bilateral types of credit risks are considered. Our study shows that credit risk should be modeled as American style options in most cases, which require a backward induction valuation. To correct a common mistake in the literature, we emphasize that the market value of a defaultable derivative is actually a risky value rather than a risk-free value. Credit value adjustment (CVA) is also elaborated. A practical framework is developed for pricing defaultable derivatives and calculating their CVAs at a portfolio level.

• Item Type: MPRA Paper
• Language: English
• Keywords: credit value adjustment (CVA), credit risk modeling, financial derivative valuation, collateralization, margin and netting.
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing; G - Financial Economics > G1 - General Financial Markets > G17 - Financial Forecasting and Simulation

References

Duffie, Darrell, and Ming Huang, 1996, Swap rates and credit quality, Journal of Finance, 51, 921-949.

Duffie, Darrell, and Kenneth J. Singleton, 1999, Modeling term structure of defaultable bonds, Review of Financial Studies, 12, 687-720.

FinPricing, 2019, Risk management system, https://finpricing.com/knowledge.html

Gregory, Jon, 2009, Being two-faced over counterparty credit risk, RISK, 22, 86-90.

Jarrow, Robert A., and Stuart M. Turnbull, 1995, Pricing derivatives on financial securities subject to credit risk, Journal of Finance, 50, 53-85.

Longstaff, Francis A., and Eduardo S. Schwartz, 1995, A simple approach to valuing risky fixed and floating debt, Journal of Finance, 50, 789-819.

Longstaff, Francis A., and Eduardo S. Schwartz, 2001, Valuing American options by simulation: a simple least-squares approach, The Review of Financial Studies, 14 (1), 113-147.

Madian, Dilip.B., and Unal, Haluk, 1998, Pricing the risks of default, Review of Derivatives Research, 2, 121-160.

Merton, Robert C., 1974, On the pricing of corporate debt: the risk structure of interest rates, Journal of Finance, 29, 449-470.

Pykhtin, Michael, and Steven Zhu, 2007, A guide to modeling counterparty credit risk, GARP Risk Review, July/August, 16-22.

Xiao, Tim, 2015, An accurate solution for credit value adjustment (CVA) and wrong way risk, Journal of Fixed Income, Summer 2015, 25(1), 84-95.