CVA Implied Vol and Netting Arbitrage Introduction

by Christian Kamtchueng of Barclays Capital & ESSEC, Paris

June 3, 2011

Abstract: After Lehman default (credit crisis which started in 2007), practitioners considered the default risk as a major risk. The Industry began to charge for the default risk of any derivatives. In this article we try to extend the work of V.Piterbarg who established the fundamental of a new world in the pricing of derivatives. Our main focus will be on the Equity CVA but can be extended to any asset class. In this article we established the default risky price of particular space of derivatives based on vanilla CVA then we introduced the CVA implied Volatility and described a new pricing methodology. It is the first time that the CVA premium is not consider as a binary relation, in this paper we established the link and arbitrage opportunities related to the derivative hedge portfolio and the CVA premium. Therefore we introduce the second order Wrong Way Risk.

Keywords: CVA, netting, arbitrage, CVA implied volatility, CVA local volatility.

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