CVA for Bilateral Counterparty Risk under Alternative Settlement Conventions

TL;DR

This paper introduces a comprehensive framework for calculating Credit Value Adjustment (CVA) for bilateral counterparty risk, incorporating systemic effects, contagion, and alternative settlement clauses, highlighting their significant impact on CVA estimates.

Contribution

It presents a novel, flexible methodology that accounts for systemic effects, contagion, and settlement variations, advancing beyond traditional models that assume risk-free or pre-default contract values.

Findings

Settlement clause variations significantly affect CVA estimates.

The proposed model captures systemic and contagion effects.

Numerical analysis confirms the importance of sophisticated CVA modeling.

Abstract

We depart from the usual methods for pricing contracts with the counterparty credit risk found in most of the existing literature. In effect, typically, these models do not account for either systemic effects or at-first-default contagion and postulate that the contract value at default equals either the risk-free value or the pre-default value. We propose instead a fairly general framework, which allows us to perform effective Credit Value Adjustment (CVA) computations for a contract with bilateral counterparty risk in the presence of systemic and wrong or right way risks. Our general methodology focuses on the role of alternative settlement clauses, but it is also aimed to cover various features of margin agreements. A comparative analysis of numerical results reported in the final section supports our initial conjecture that alternative specifications of settlement values have a non-negligible impact on the CVA computation for contracts with bilateral counterparty risk. This emphasizes the practical importance of more sophisticated models that are capable of fully reflecting the actual features of financial contracts, as well as the influence of the market environment.