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Interest Rate Swap Credit Valuation Adjustment

Author

Listed:
  • Jakub Cerny

    () (Charles University in Prague, Faculty of Mathematics and Physics Department of Probability and Mathematical Statistics, Sokolovska 83, 186 75, Prague, Czech Republic)

  • Jiri Witzany

    () (University of Economics, Faculty of Finance and Accounting, Department of Banking and Insurance, W. Churchill Sq. 4, 130 67, Prague, Czech Republic)

Abstract

The credit valuation adjustment (CVA) of OTC derivatives is an important part of the Basel III credit risk capital requirements and current accounting rules. Its calculation is not an easy task - not only it is necessary to model the future value of the derivative, but also the probability of default of a counterparty. Another complication arises in the calculation when the exposure to a counterparty is adversely correlated with the credit quality of that counterparty, i.e. when it is needed to incorporate the wrong-way risk. A semi-analytical CVA formula simplifying the interest rate swap (IRS) valuation with the counterparty credit risk including the wrong-way risk is derived and analyzed in the paper. The formula is based on the fact that the CVA of an IRS can be expressed using swaption prices. The link between the interest rates and the default time is represented by a Gaussian copula with constant correlation coefficient. Finally, the results of the semi-analytical approach are compared with the results of a complex simulation study.

Suggested Citation

  • Jakub Cerny & Jiri Witzany, 2014. "Interest Rate Swap Credit Valuation Adjustment," Working Papers IES 2014/16, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised May 2014.
  • Handle: RePEc:fau:wpaper:wp2014_16
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    File URL: http://ies.fsv.cuni.cz/sci/publication/show/id/5090/lang/cs
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    Keywords

    Counterparty Credit Risk; Credit Valuation Adjustment; Wrong-way Risk; Risky Swaption Price; Semi-analytical Formula; Interest Rate Swap Pricecointegration test;

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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