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Bilateral Credit Valuation Adjustment of an Optional Early Termination Clause

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  • Lorenzo Giada
  • Claudio Nordio
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    Abstract

    Is an option to early terminate a swap at its market value worth zero? At first sight it is, but in presence of counterparty risk it depends on the criteria used to determine such market value. In case of a single uncollateralised swap transaction under ISDA between two defaultable counterparties, the additional unilateral option to early terminate the swap at predefined dates requires a Bermudan credit valuation adjustment. We give a general pricing formula assuming a default-free close-out amount, and apply it in a simplified setting with deterministic intensity and one single date of optional early termination, showing that the impact on the fair value of the transaction at inception might be non negligible.

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    File URL: http://arxiv.org/pdf/1205.2013
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    Paper provided by arXiv.org in its series Papers with number 1205.2013.

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    Date of creation: May 2012
    Date of revision: Jan 2013
    Handle: RePEc:arx:papers:1205.2013

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    Web page: http://arxiv.org/

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    1. Damiano Brigo & Massimo Morini, 2010. "Dangers of Bilateral Counterparty Risk: the fundamental impact of closeout conventions," Papers 1011.3355, arXiv.org.
    2. Damiano Brigo & Cristin Buescu & Massimo Morini, 2011. "Impact of the first to default time on Bilateral CVA," Papers 1106.3496, arXiv.org.
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