Presenter: Harvey Stein: Head, Regulation and Credit Modeling, Bloomberg

Abstract

Despite recent market upheavals, the OTC derivatives markets continue to comprise one of the largest components of the financial markets. Prompted by the desire to weather or even reduce market turmoil, approaches for analyzing and mitigating counterparty risk have garnered renewed interest. Regulators have been advocating greater usage of clearing houses. Accounting boards have been refining and codifying fair market valuation, placing additional emphasis on careful consideration of counterparty risk. And investors and traders have been trying to better factor some notion of counterparty risk into their trading and risk management practices. Here we will investigate the notion of counterparty risk and the associated credit valuation adjustment (CVA) in the fixed income markets. We will:

• Outline the CVA calculation, contrasting the counterparty risk for a bond with that of an interest rate swap,
• Detail the underlying model assumptions,
• Give examples of the calculation,
• Discuss the impact the CVA has in the value of these instruments,
• Discuss risk mitigation techniques,
• Review Basel III CVA capital requirements, and
• Investigate the theory and computation of the FVA