Interest Rate Swap Credit Valuation Adjustment

IES Working Paper: 16/2014

https://doi.org/10.3905/jod.2015.23.2.024

Posted: 20 May 2019

See all articles by Jakub Cerny

Jakub Cerny

Charles University in Prague - Faculty of Mathematics and Physics

Jiri Witzany

University of Economics in Prague

Date Written: May 2014

Abstract

The credit valuation adjustment (CVA) of OTC derivatives is an important part of the Basel III credit risk capital requirements and current accounting rules. Its calculation is not an easy task - not only it is necessary to model the future value of the derivative, but also the probability of default of a counterparty. Another complication arises in the calculation when the exposure to a counterparty is adversely correlated with the credit quality of that counterparty, i.e. when it is needed to incorporate the wrong-way risk. A semi-analytical CVA formula simplifying the interest rate swap (IRS) valuation with the counterparty credit risk including the wrong-way risk is derived and analyzed in the paper. The formula is based on the fact that the CVA of an IRS can be expressed using swaption prices. The link between the interest rates and the default time is represented by a Gaussian copula with constant correlation coefficient.Finally, the results of the semi-analytical approach are compared with the results of a complex simulation study.

Keywords: Counterparty Credit Risk, Credit Valuation Adjustment, Wrong-way Risk, Risky Swaption Price, Semi-analytical Formula, Interest Rate Swap Price

JEL Classification: C63, G12, G13, G32

Suggested Citation

Cerny, Jakub and Witzany, Jiri, Interest Rate Swap Credit Valuation Adjustment (May 2014). IES Working Paper: 16/2014. Available at SSRN: https://ssrn.com/abstract=2302519 or http://dx.doi.org/10.2139/ssrn.2302519

Jakub Cerny (Contact Author)

Charles University in Prague - Faculty of Mathematics and Physics ( email )

Sokolovska 83
Prague, 186 75
Czech Republic

Jiri Witzany

University of Economics in Prague ( email )

Winston Churchilla Sq. 4
Prague 3, 130 67
Czech Republic

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