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Pricing Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment

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  • David Lee

Abstract

This article presents a generic model for pricing financial derivatives subject to counterparty credit risk. Both unilateral and bilateral types of credit risks are considered. Our study shows that credit risk should be modeled as American style options in most cases, which require a backward induction valuation. To correct a common mistake in the literature, we emphasize that the market value of a defaultable derivative is actually a risky value rather than a risk-free value. Credit value adjustment (CVA) is also elaborated. A practical framework is developed for pricing defaultable derivatives and calculating their CVAs at a portfolio level.

Suggested Citation

  • David Lee, 2018. "Pricing Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment," Papers 1804.02289, arXiv.org.
    • Handle: RePEc:arx:papers:1804.02289
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    File URL: http://arxiv.org/pdf/1804.02289
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    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D46 - Microeconomics - - Market Structure, Pricing, and Design - - - Value Theory
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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