Credit Value Adjustment (CVA) Introduction Alex Yang FinPricing

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Presentation transcript:

Credit Value Adjustment (CVA) Introduction Alex Yang FinPricing http://www.finpricing.com

Summary CVA Introduction CVA History CVA Definition Risk Free Valuation Risky Valuation http://www.finpricing.com/lib/cva.pptx

CVA History CVA Introduction Current market practice Discounting using the LIBOR or risk-free curves Using risk-free value for pricing, hedging, P&L Real counterparty reality Having different credit qualities from LIBOR Having risk of default ISA 39 (International Accounting Standard) Requiring CVA in 2000 (mandatory) Finance and Accounting owning CVA Receiving a little attention in the beginning Becoming significant risk after financial crises http://www.finpricing.com/lib/cva.pptx

CVA Definition CVA Introduction Definition CVA = Risk free value – True (risky) value Benefits Quantifying counterparty risk as a single P&L number Dynamically managing, pricing, and hedging counterparty risk Notes CVA is a topic of valuation and requires accurate pricing and risk- neutral measure Risk-free valuation is what we use every day. Risky valuation is less explored and less transparent http://www.finpricing.com/lib/cva.pptx

Risk-Free Valuation CVA Introduction The risk-free valuation is what brokers quote or what trading systems or models normally report. A simple example to illustrate A zero coupon bond paying X at T The risk-free value where r is risk-free interest rate and is risk-free discount factor http://www.finpricing.com/lib/cva.pptx

Risky Valuation CVA Introduction Default Modeling Structural models Studying default based on capital structure of a firm Reduced form models Characterizing default as a jump (Poisson) process Market practitioners prefer the reduced form models due to Mathematical tractability Consistency with market observations as risk-neutral default probabilities can be backed out from bond prices and CDS spreads http://www.finpricing.com/lib/cva.pptx

Risky Valuation (Continuously Defaultable) CVA Introduction Risky Valuation (Continuously Defaultable) The same simple example: a zero coupon bond paying X at T The risk value where r is risk-free interest rate and s is credit spread is risk adjusted discounting factor CVA by defintion http://www.finpricing.com/lib/cva.pptx

Risky Valuation (Discrete Defaultable) CVA Introduction Risky Valuation (Discrete Defaultable) Assumption default may happen only at the payment date At time T, the bond either survives with payoff X or defaults with payoff where 𝜑 is the recovery rate Risk value where p is default probability and q=1-p is the survival probability CVA http://www.finpricing.com/lib/cva.pptx

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