Liability-side Pricing of Swaps and Coherent CVA and FVA by Regression/Simulation

Wujiang Lou

Papers from arXiv.org

Abstract: An uncollateralized swap hedged back-to-back by a CCP swap is used to introduce FVA. The open IR01 of FVA, however, is a sure sign of risk not being fully hedged, a theoretical no-arbitrage pricing concern, and a bait to lure market risk capital, a practical business concern. By dynamically trading the CCP swap, with the liability-side counterparty provides counterparty exposure hedge and swap funding, we find that the uncollateralized swap can be fully replicated, leaving out no IR01 leakage. The fair value of the swap is obtained by applying to swap's net cash flows a discount rate switching to counterparty's bond curve if the swap is a local asset or one's own curve if a liability, and the total valuation adjustment is the present value of cost of funding the risk-free price discounted at the same switching rate. FVA is redefined as a liquidity or funding basis component of total valuation adjustment, coherent with CVA, the default risk component. A Longstaff-Schwartz style least-square regression and simulation is introduced to compute the recursive fair value and adjustments. A separately developed finite difference scheme is used to test and find regression necessary to decouple the discount rate switch. Preliminary results show the impact of counterparty risk to swap hedge ratios, swap bid/ask spreads, and valuation adjustments, and considerable errors of calculating CVA by discounting cash flow or potential future exposure.

Date: 2015-12
New Economics Papers: this item is included in nep-cmp
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Published in Liability-side pricing of swaps, RISK, April 2016, pp 66-71

Downloads: (external link)
http://arxiv.org/pdf/1512.07340 Latest version (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1512.07340

Access Statistics for this paper

More papers in Papers from arXiv.org
Bibliographic data for series maintained by arXiv administrators ().