An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk

Posted: 21 May 2013 Last revised: 23 May 2019

See all articles by Tim Xiao

Tim Xiao

Risk Models, BMO Capital Markets

Date Written: June 1, 2015

Abstract

This paper presents a Least Square Monte Carlo approach for accurately calculating credit value adjustment (CVA). In contrast to previous studies, the model relies on the probability distribution of a default time/jump rather than the default time itself, as the default time is usually inaccessible. As such, the model can achieve a high order of accuracy with a relatively easy implementation. We find that the valuation of a defaultable derivative is normally determined via backward induction when their payoffs could be positive or negative. Moreover, the model can naturally capture wrong or right way risk.

Keywords: credit value adjustment (CVA), wrong way risk, right way risk, credit risk modeling, risky valuation, default time approach (DTA), default probability approach (DPA), collateralization, margin and netting

JEL Classification: E44, G21, G12, G24, G32, G33, G18, G28

Suggested Citation

Xiao, Tim, An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk (June 1, 2015). Journal of Fixed Income, 2015, https://doi.org/10.3905/jfi.2015.25.1.084. Available at SSRN: https://ssrn.com/abstract=2267508 or http://dx.doi.org/10.2139/ssrn.2267508

Tim Xiao (Contact Author)

Risk Models, BMO Capital Markets ( email )

Canada

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