Counterparty Risk and Funding: The Four Wings of the TVA

TL;DR

This paper summarizes and numerically analyzes the TVA pricing problem, reducing it to Markovian BSDEs, and assesses model risk through interest rate swap examples in different short rate models.

Contribution

It provides an executive summary and numerical methods for TVA valuation, linking theoretical TVA BSDEs to practical interest rate swap applications and model risk assessment.

Findings

TVA can be priced using Markovian BSDEs.

Numerical results demonstrate model risk in interest rate swaps.

Assessment of TVA in Vasicek and Hull-White models.

Abstract

The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely the counterparty risk. The related Credit Valuation Adjustment, (CVA), Debt Valuation Adjustment (DVA), Liquidity Valuation Adjustment (LVA) and Replacement Cost (RC) issues, jointly referred to in this paper as Total Valuation Adjustment (TVA), have been thoroughly investigated in the theoretical papers [Cr12a] and [Cr12b]. The present work provides an executive summary and numerical companion to these papers, through which the TVA pricing problem can be reduced to Markovian pre-default TVA BSDEs. The first step consists in the counterparty clean valuation of a portfolio of contracts, which is the valuation in a hypothetical situation where the two parties would be risk-free and funded at a risk-free rate. In the second step, the TVA is obtained as the value of an option on the counterparty clean value process called Contingent Credit Default Swap (CCDS). Numerical results are presented for interest rate swaps in the Vasicek, as well as in the inverse Gaussian Hull-White short rate model, also allowing one to assess the related model risk issue.