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Credit Derivative Evaluation and CVA under the Benchmark Approach

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Abstract

In this paper, we discuss how to model credit risk under the benchmark approach. Firstly we introduce an affine credit risk model. We then show how to price credit default swaps (CDSs) and introduce credit valuation adjustment (CVA) as an extension of CDSs. In particular, our model can capture right-way - and wrong-way exposure. This means, we capture the dependence structure of the default event and the value of the transaction under consideration. For simple contracts, we provide closed-form solutions. However, due to the fact that we allow for a dependence between the default event and the value of the transaction, closed-form solutions are difficult to obtain in general. Hence we conclude this paper with a reduced form model, which is more tractable.

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File URL: http://www.qfrc.uts.edu.au/research/research_papers/rp324.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 324.

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Length: 27
Date of creation: 01 Feb 2013
Date of revision:
Handle: RePEc:uts:rpaper:324

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Keywords: Credit derivatives; credit valuation adjustment; benchmark approach; affine processes; real world pricing;

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  1. Eckhard Platen, 2004. "A Benchmark Approach to Finance," Research Paper Series 138, Quantitative Finance Research Centre, University of Technology, Sydney.
  2. Eckhard Platen & Renata Rendek, 2010. "Approximating the Numeraire Portfolio by Naive Diversification," Research Paper Series 281, Quantitative Finance Research Centre, University of Technology, Sydney.
  3. Eckhard Platen, 2002. "A Benchmark Framework for Integrated Risk Management," Research Paper Series 82, Quantitative Finance Research Centre, University of Technology, Sydney.
  4. Damiano Brigo & Kyriakos Chourdakis, 2009. "Counterparty Risk For Credit Default Swaps: Impact Of Spread Volatility And Default Correlation," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(07), pages 1007-1026.
  5. 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.
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