Chapter 24 - Counterparty Risk, Multiple Curves, CVA, DVA, and FVA

Abstract

The objective of this chapter is to introduce the reader to recent innovations and market practice in financial engineering and derivatives pricing related to counterparty risk. Counterparty risk is intimately related to the cost and funding of derivatives transactions and the market maker perspective that we take throughout this book. We introduce adjustments to the default-free value of derivative contracts from the perspective of a bank to reflect the credit risk of the bank’s counterparty (credit valuation adjustment or CVA) and the own credit risk of the bank (debit valuation adjustment or DVA). CVA is shown to resemble an option on the residual value of the portfolio with a random maturity given the default time of the counterparty. We discuss how the default probability can be estimated based on CDS prices, for example. We introduce funding value (adjustment) which reflects the entity’s funding cost. We present recent case studies and numerical examples to illustrate CVA valuation in practice. We discuss CVA hedging, contingent CDS and the role of credit support annexes and so-called CVA desks. We discuss recent changes in market practice such as overnight swap index discounting and point to the recent debate regarding funding valuation adjustment and the choice of the riskless rate proxy.