Credit Value Adjustment: The Aspects of Pricing Counterparty Credit Risk on Interest Rate Swaps

Sammanfattning: In this thesis, the pricing of counterparty credit risk on an OTC plain vanilla interest rate swap is investigated. Counterparty credit risk can be defined as the risk that a counterparty in a financial contract might not be able or willing to fulfil their obligations. This risk has to be taken into account in the valuation of an OTC derivative. The market price of the counterparty credit risk is known as the Credit Value Adjustment (CVA). In a bilateral contract, such as a swap, the party’s own creditworthiness also has to be taken into account, leading to another adjustment known as the Debit Value Adjustment (DVA). Since 2013, the international accounting standards (IFRS) states that these adjustments have to be done in order to reflect the fair value of an OTC derivative. A short background and the derivation of CVA and DVA is presented, including related topics like various risk mitigation techniques, hedging of CVA, regulations etc.. Four different pricing frameworks are compared, two more sophisticated frameworks and two approximative approaches. The most complex framework includes an interest rate model in form of the LIBOR Market Model and a credit model in form of the Cox-Ingersoll- Ross model. In this framework, the impact of dependencies between credit and market risk factors (leading to wrong-way/right-way risk) and the dependence between the default time of different parties are investigated.