Credit Value Adjustment for Counterparties with Illiquid CDS

TL;DR

This paper addresses the challenge of estimating credit value adjustment (CVA) in illiquid markets lacking liquid CDS, proposing a model to estimate real-world default probabilities using minimal market data, aligning with IFRS 13.

Contribution

It introduces a novel approach to estimate real-world default probabilities in illiquid markets without liquid CDS, suitable for CVA calculation and compliant with IFRS 13.

Findings

Proposes a model for default time estimation in illiquid markets.

Shows the use of real-world probabilities in CVA valuation.

Provides a method to estimate default probabilities using limited market data.

Abstract

Credit Value Adjustment (CVA) is the difference between the value of the default-free and credit-risky derivative portfolio, which can be regarded as the cost of the credit hedge. Default probabilities are therefore needed, as input parameters to the valuation. When liquid CDS are available, then implied probabilities of default can be derived and used. However, in small markets, like the Nordic region of Europe, there are practically no CDS to use. We study the following problem: given that no liquid contracts written on the default event are available, choose a model for the default time and estimate the model parameters. We use the minimum variance hedge to show that we should use the real-world probabilities, first in a discrete time setting and later in the continuous time setting. We also argue that this approach should fulfil the requirements of IFRS 13, which means it could be used in accounting as well. We also present a method that can be used to estimate the real-world probabilities of default, making maximal use of market information (IFRS requirement).