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LEAST SQUARES MONTE CARLO CREDIT VALUE ADJUSTMENT WITH SMALL AND UNIDIRECTIONAL BIAS

Mark Joshi () and Oh Kang Kwon
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Mark Joshi: Centre for Actuarial Studies, Department of Economics, University of Melbourne, VIC 3010, Australia
Oh Kang Kwon: Discipline of Finance, Codrington Building (H69), The University of Sydney, NSW 2006, Australia

International Journal of Theoretical and Applied Finance (IJTAF), 2016, vol. 19, issue 08, 1-16

Abstract: Credit value adjustment (CVA) and related charges have emerged as important risk factors following the Global Financial Crisis. These charges depend on uncertain future values of underlying products, and are usually computed by Monte Carlo simulation. For products that cannot be valued analytically at each simulation step, the standard market practice is to use the regression functions from least squares Monte Carlo method to approximate their values. However, these functions do not necessarily provide accurate approximations to product values over all simulated paths and can result in biases that are difficult to control. Motivated by a novel characterization of the CVA as the value of an option with an early exercise opportunity at a stochastic time, we provide an approximation for CVA and other credit charges that rely only on the sign of the regression functions. The values are determined, instead, by pathwise deflated cash flows. A comparison of CVA for Bermudan swaptions and cancellable swaps shows that the proposed approximation results in much smaller errors than the standard approach of using the regression function values.

Keywords: Credit value adjustment; least squares regression; Monte Carlo simulation (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (6)

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DOI: 10.1142/S0219024916500485

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