the web's biggest credit risk modeling resource.

Credit Jobs

Home Glossary Links FAQ / About Site Guide Search


Submit Your Paper

In Rememberance: World Trade Center (WTC)

doi> search: A or B

Export citation to:
- Text (plain)
- BibTeX

Bilateral Counterparty Risk Valuation for Interest-rate Products: Impact of volatilities and correlations

by Damiano Brigo of Imperial College & Fitch Solutions,
Andrea Pallavicini of Banca Leonardo, and
Vasileios Papatheodorou of Fitch Solutions

February 3, 2010

Abstract: The purpose of this paper is introducing rigorous methods and formulas for bilateral counterparty risk credit valuation adjustments (CVA's) on interest-rate portfolios. In doing so, we summarize the general arbitrage-free valuation framework for counterparty risk adjustments in presence of bilateral default risk, as developed more in detail in Brigo and Capponi (2008), including the default of the investor. We illustrate the symmetry in the valuation and show that the adjustment involves a long position in a put option plus a short position in a call option, both with zero strike and written on the residual net present value of the contract at the relevant default times. We allow for correlation between the default times of the investor and counterparty, and for correlation of each with the underlying risk factor, namely interest rates. We also analyze the often neglected impact of credit spread volatility. We include Netting in our examples, although other agreements such as Margining and Collateral are left for future work.

JEL Classification: C15, C63, C65, G12, G13.

AMS Classification: 60H10, 60J60, 60J75, 62H20, 91B70.

Keywords: Counterparty Risk, Arbitrage-Free Credit Valuation Adjustment, Interest Rate Swaps, Interest Rate Derivatives, Credit Valuation Adjustment, Bilateral Risk, Credit Spread Volatility, Default Correlation, Stochastic Intensity, Short Rate Models, Copula Functions, Wrong Way Risk.

Books Referenced in this paper:  (what is this?)

Download paper (451K PDF) 23 pages