Impact of the first to default time on Bilateral CVA
AbstractWe compare two different bilateral counterparty valuation adjustment (BVA) formulas. The first formula is an approximation and is based on subtracting the two unilateral Credit Valuation Adjustment (CVA)'s formulas as seen from the two different parties in the transaction. This formula is only a simplified representation of bilateral risk and ignores that upon the first default closeout proceedings are ignited. As such, it involves double counting. We compare this formula with the fully specified bilateral risk formula, where the first to default time is taken into account. The latter correct formula depends on default dependence between the two parties, whereas the simplified one does not. We also analyze a candidate simplified formula in case the replacement closeout is used upon default, following ISDA's recommendations, and we find the simplified formula to be the same as in the risk free closeout case. We analyze the error that is encountered when using the simplified formula in a couple of simple products: a zero coupon bond, where the exposure is unidirectional, and an equity forward contract where exposure can go both ways. For the latter case we adopt a bivariate exponential distribution due to Gumbel to model the joint default risk of the two parties in the deal. We present a number of realistic cases where the simplified formula differs considerably from the correct one.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1106.3496.
Date of creation: Jun 2011
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- Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2012. "Funding, Collateral and Hedging: uncovering the mechanics and the subtleties of funding valuation adjustments," Papers 1210.3811, arXiv.org, revised Dec 2012.
- Lorenzo Giada & Claudio Nordio, 2012. "Bilateral Credit Valuation Adjustment of an Optional Early Termination Clause," Papers 1205.2013, arXiv.org, revised Jan 2013.
- Lorenzo Giada & Claudio Nordio, 2012. "Funded Bilateral Valuation Adjustment," Papers 1211.1564, arXiv.org.
- Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2011. "Funding Valuation Adjustment: a consistent framework including CVA, DVA, collateral,netting rules and re-hypothecation," Papers 1112.1521, arXiv.org, revised Dec 2011.
- Damiano Brigo, 2011. "Counterparty Risk FAQ: Credit VaR, PFE, CVA, DVA, Closeout, Netting, Collateral, Re-hypothecation, WWR, Basel, Funding, CCDS and Margin Lending," Papers 1111.1331, arXiv.org, revised Jun 2012.
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