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A computational approach to hedging Credit Valuation Adjustment in a jump-diffusion setting

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  • van der Zwaard, Thomas
  • Grzelak, Lech A.
  • Oosterlee, Cornelis W.

Abstract

This study contributes to understanding Valuation Adjustments (xVA) by focussing on the dynamic hedging of Credit Valuation Adjustment (CVA), corresponding Profit & Loss (P&L) and the P&L explain. This is done in a Monte Carlo simulation setting, based on a theoretical hedging framework discussed in existing literature. We look at hedging CVA market risk for a portfolio with European options on a stock, first in a Black-Scholes setting, then in a Merton jump-diffusion setting. Furthermore, we analyze the trading business at a bank after including xVAs in pricing. We provide insights into the hedging of derivatives and their xVAs by analyzing and visualizing the cash-flows of a portfolio from a desk structure perspective. The case study shows that not charging CVA at trade inception results in an expected loss. Furthermore, hedging CVA market risk is crucial to end up with a stable trading strategy. In the Black-Scholes setting this can be done using the underlying stock, whereas in the Merton jump-diffusion setting we need to add extra options to the hedge portfolio to properly hedge the jump risk. In addition to the simulation, we derive analytical results that explain our observations from the numerical experiments. Understanding the hedging of CVA helps to deal with xVAs in a practical setting.

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  • van der Zwaard, Thomas & Grzelak, Lech A. & Oosterlee, Cornelis W., 2021. "A computational approach to hedging Credit Valuation Adjustment in a jump-diffusion setting," Applied Mathematics and Computation, Elsevier, vol. 391(C).
    • Handle: RePEc:eee:apmaco:v:391:y:2021:i:c:s009630032030624x
    DOI: 10.1016/j.amc.2020.125671
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    1. T. van der Zwaard & L. A. Grzelak & C. W. Oosterlee, 2022. "Efficient Wrong-Way Risk Modelling for Funding Valuation Adjustments," Papers 2209.12222, arXiv.org, revised Mar 2023.
    2. T. van der Zwaard & L. A. Grzelak & C. W. Oosterlee, 2022. "Relevance of Wrong-Way Risk in Funding Valuation Adjustments," Papers 2204.02680, arXiv.org, revised Jun 2022.
    3. van der Zwaard, Thomas & Grzelak, Lech A. & Oosterlee, Cornelis W., 2022. "Relevance of Wrong-Way Risk in Funding Valuation Adjustments," Finance Research Letters, Elsevier, vol. 49(C).

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