Recently I was asked by a student to give some guidance on using Monte Carlo method for CVA calculation. Here is what I came up with. Advertisements
Let’s calculate CVA (credit value adjustment) analytically. We will see that analytical CVA calculation is quite complex even for a fairly simple transaction (a vanilla swap). A few shortcuts will help us simplify the calculation.
When we have to calculate exposure at default (EAD) on a particular trade, we seldom have to compute it analytically (e.g. as shown here). More often we just take the current MtM of the trade and add the so-called add-on. … Continue reading
To calculate counterparty exposure, we need to calibrate our scenario generator to historical data. However, for CVA calculations, we need scenarios based on implied volatilities of the underlying risk factors. Continue reading
Potential exposure is not additive: the total exposure on two trades can be very different than the sum of potential exposures on each trade. Continue reading
This paper by S. Zhu and M. Pykhtin provides a blueprint for counterparty risk modelling framework.
Exposure at default calculation for one contract can be done analytically, but for a big portfolio one has to resort to Monte-Carlo simulation. Continue reading