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

40 Pages Posted: 20 Aug 2019

See all articles by Tim Xiao

Tim Xiao

Risk Models, BMO Capital Markets

Date Written: August 17, 2019

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.

Keywords: credit value adjustment (CVA), credit risk modeling, financial derivative valuation, collateralization, margin and netting

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

Suggested Citation

Xiao, Tim, The Valuation of Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment (August 17, 2019). Available at SSRN: https://ssrn.com/abstract=3438704 or http://dx.doi.org/10.2139/ssrn.3438704

Tim Xiao (Contact Author)

Risk Models, BMO Capital Markets ( email )

Canada

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
32
Abstract Views
254
PlumX Metrics