Modelling, pricing, and hedging counterparty credit exposure. A technical guide (Q1039395)

The authors are experts of a major investment bank. In this book they describe some of their experience in modelling counterparty credit exposure, computing credit valuation adjustments, determining appropriate hedges, and building a reliable system. The presented approach to counterparty credit exposure analysis is quantitative. The focus is on mathematical modelling, simulation techniques using various Monte Carlo approaches, and pricing. Derivative products and complex structures are considered which are usually traded by investment banks. All models used in the presented analyses are tested with practical data and real transactions. The authors sometimes refer to their work as credit quantification. The reviewed book is divided into four parts, (I) Methodology, (II) Architecture and Implementation, (III) Products, and (IV) Hedging and Managing Counterparty Risk. In part I the authors present a generic simulation framework, which can be used to compute counterparty exposure for both vanilla and exotic products. They show how the classical Monte Carlo framework, where price distributions are computed by generating thousands of scenarios and by explicitly pricing the product at each point in time and at each scenario, is a special case of their more general framework. Part II shows how our simulation framework naturally leads to the implementation of a software architecture and the definition of a programming language that allows the computation of both vanilla and exotic products in a scenario-consistent way. The authors show that their approach leads to an architecture that can integrate other systems in a natural way. In part III the authors consider how to compute exposure for different products. They show how the general techniques and models described in part I and the architecture described in part II can be used in practice. Finally, in part IV things are put together. The authors consider how to perform risk management and risk control of counterparty exposure on a portfolio basis. They describe different aggregation techniques and a standard set-up that uses collateral to mitigate exposure. They also analyse how to model wrong-way/right-way exposure, where transaction price fluctuations and quality of the counterparty are correlated and we address the problem of changing the reference probability measure after the simulation has been performed. The final chapter is dedicated to pricing counterparty credit exposure and to computing credit valuation adjustment (CVA). Moreover there are presented CVA sensitivities not only to credit spread, but also to market risk factors. The whole book can be seen as a roadmap to achieve this goal. This book describes well-established simulation and pricing techniques. Its goal is not to suggest new or more sophisticated algorithms. It is rather to show how well-known algorithms can be put together and used to compute counterparty credit exposure and which limitations have to be taken into consideration if we want to move from vanilla products to complex exotic transactions.