Advanced counterparty risk pricing and restructuring: CVA, DVA, Closeout, Netting, Collateral, Basel III, systemic risk and Margin Lending

Although explicit pricing of counterparty credit risk in the financial modeling literature goes way back to 1994, it is only after the eight credit events that happened in one month of 2008 that the research environment has become increasingly active in modeling the related credit valuation adjustments (CVA). Basel III is also imposing heavy capital requirements on CVA after finding that about 2/3 of the losses during the crisis are due to CVA mark to market volatility rather than to actual defaults. The reason why the pricing of counterparty risk has been twice as dangerous as the actual risk itself will be explained in this talk. We introduce the mathematics of CVA and explain why it is a difficult hybrid derivatives valuation problem. Subtleties on payoff and modeling mathematics including wrong way risk, closeout conventions, first to default risk, collateral modeling, re-hypothecation and gap risk are investigated with quantitative case studies from a few asset classes. General conclusions on the mathematical difficulties involved in CVA pricing and risk management are presented.