Pricing Financial Derivatives Subject to Counterparty Risk and Credit Value Adjustment

TL;DR

This paper introduces a comprehensive model for pricing derivatives with counterparty risk, emphasizing the importance of American-style options and providing a practical framework for CVA calculation at the portfolio level.

Contribution

It presents a generic, backward induction-based model for pricing defaultable derivatives considering both unilateral and bilateral credit risks, correcting common misconceptions.

Findings

Credit risk modeled as American options requiring backward induction

Market value of defaultable derivatives is risky, not risk-free

Framework enables portfolio-level CVA calculation

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.