Handling Exotic Positions for Counterparty Risk Management

by Shahram Alavian of Lehman Brothers International Europe

June 12, 2010

Abstract: This paper proposes a simple approach for incorporating the difficult-to-value trades to the rest of counterparty portfolios using the existing and already-approved pricing models. It requires simulating only the risk factors that these pricers require for the population of Monte Carlo simulation paths. A smaller subset of paths can be used to generate a path of trade values using these pricers. An appropriate set of basis functions over the risk factors can be selected in order to model the conditional expectation values and use the model to map the conditional values to the population. However, it is assumed that the input and output values of the pricers are properly manipulated in order to create the appropriate path-dependency. The approach is applied to the case of in-the-money American put option where the counterparty risk exposure profiles are compared between the full valuation and the valuations using this method for various path numbers. The case is extended to a null value portfolio composed of two offsetting options where one is priced using the benchmark method and another using the proposed approach for various path numbers.

Keywords: Counterparty Risk, Exotic Trades

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