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

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  • Xiao, Tim

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.

Suggested Citation

  • Xiao, Tim, 2020. "The Valuation of Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment," arabixiv.org ep9dn, Center for Open Science.
    • Handle: RePEc:osf:arabix:ep9dn
    DOI: 10.31219/osf.io/ep9dn
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    1. Xiao, Tim, 2015. "An Accurate Solution for Credit Valuation Adjustment (CVA) and Wrong Way Risk," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 25(1), pages 84-95.
    2. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
    3. Longstaff, Francis A & Schwartz, Eduardo S, 1995. "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    4. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    5. Xiao, Tim, 2013. "An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk," MPRA Paper 47104, University Library of Munich, Germany.
    6. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
    7. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
    8. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," The Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    9. Tim Xiao, 2015. "An Accurate Solution for Credit Valuation Adjustment and Wrong Way Risk," Post-Print hal-01810490, HAL.
    10. Duffie, Darrell & Huang, Ming, 1996. "Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-949, July.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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