Pricing Counterparty Risk at the Trade Level and CVA Allocations

FEDS Working Paper No. 10

Journal of Credit Risk, 6(4), 2010, pages 3-38

40 Pages Posted: 9 Mar 2011

See all articles by Michael Pykhtin

Michael Pykhtin

Board of Governors of the Federal Reserve System

Dan Rosen

(IIE) Institute of International Education

Date Written: February 1, 2010

Abstract

We address the problem of allocating the counterparty-level credit valuation adjustment (CVA) to the individual trades composing the portfolio. We show that this problem can be reduced to calculating contributions of the trades to the counterparty-level expected exposure (EE) conditional on the counterparty's default. We propose a methodology for calculating conditional EE contributions for both collateralized and non-collateralized counterparties. Calculation of EE contributions can be easily incorporated into exposure simulation processes that already exist in a financial institution. We also derive closed-form expressions for EE contributions under the assumption that trade values are normally distributed. Analytical results are obtained for the case when the trade values and the counterparty's credit quality are independent as well as when there is a dependence between them (wrong-way risk).

Keywords: CVA, counterparty risk, derivatives, credit exposure, Euler allocations, simulation, wrong-way risk

Suggested Citation

Pykhtin, Michael and Rosen, Dan, Pricing Counterparty Risk at the Trade Level and CVA Allocations (February 1, 2010). FEDS Working Paper No. 10, Journal of Credit Risk, 6(4), 2010, pages 3-38, Available at SSRN: https://ssrn.com/abstract=1782063 or http://dx.doi.org/10.2139/ssrn.1782063

Michael Pykhtin (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://www.federalreserve.gov/econresdata/michael-v-pykhtin.htm

Dan Rosen

(IIE) Institute of International Education ( email )

1400 K Street NW, Suite 700
Washington, DC STOCKHOLM 20005-2403
United States

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