Counterparty risk and funding : a tale of two puzzles

 Content: Financial Landscape  A Galilean Dialogue on Counterparty Risk, CVA, DVA, Multiple Curves, Collateral, and Funding  To the Discerning Reader  The First Day  The Second Day  The Third Day  The Fourth Day   The Whys of the LOIS  Financial Setup  Indifference Valuation Model  LOIS Formula  Numerical Study   Model-Free Developments Pure Counterparty Risk  Cash Flows  Valuation and Hedging  CSA Specifications   Bilateral Counterparty Risk under Funding Constraints  Introduction  Market Model  Trading Strategies  Martingale Pricing Approach  TVA  Example   Reduced-Form BSDE Modeling  A Reduced-Form TVA BSDE Approach to Counterparty Risk under Funding Constraints  Introduction  Pre-Default BSDE Modeling  Markov Case   The Four Wings of the TVA  Introduction  TVA Representations  CSA Specifications  Clean Valuations  TVA Computations   Dynamic Copula Models  Dynamic Gaussian Copula Model  Introduction  Model  Clean Valuation and Hedging of Credit Derivatives  Counterparty Risk   Common-Shock Model  Introduction  Model of Default Times  Clean Pricing, Calibration and Hedging  Numerical Results  CVA Pricing and Hedging   CVA Computations for one CDS in the Common-Shock Model  Introduction  Generalities  Common-Shock Model with Deterministic Intensities  Numerical Results with Deterministic Intensities  Common-Shock Model with Stochastic Intensities  Numerics   CVA Computations for Credit Portfolios in the Common-Shock Model  Portfolio of CDS  CDO Tranches   Further Developments  Rating Triggers and Credit Migrations  Introduction  Credit Value Adjustment and Collateralization under Rating Triggers  Markov Copula Approach for Rating-Based Pricing  Applications   A Unified Perspective Introduction  Marked Default Time Reduced-Form Modeling  Dynamic Gaussian Copula TVA Model  Dynamic Marshall-Olkin Copula TVA Model   Mathematical Appendix  Stochastic Analysis Prerequisites  Stochastic Integration  Ito Processes  Jump-Diffusions  Feynman-Kac Formula  Backward Stochastic Differential Equations  Measure Changes and Random Intensity of Jumps  Reduction of Filtration and Hazard Intensity Pre-Default Credit Risk Modeling  Markov Consistency and Markov Copulas  Introduction  Consistent Markov Processes  Markov Copulas  Examples   Index
 Abstract:             "Solve the DVA/FVA Overlap Issue and Effectively Manage Portfolio Credit RiskCounterparty Risk and Funding: A Tale of Two Puzzles explains how to study risk embedded in financial transactions between the bank and its counterparty. The authors provide an analytical basis for the quantitative methodology of dynamic valuation, mitigation, and hedging of bilateral counterparty risk on over-the-counter (OTC) derivative contracts under funding constraints. They explore credit, debt, funding, liquidity, and rating valuation adjustment (CVA, DVA, FVA, LVA, and RVA) as well as replacement cost (RC), wrong-way risk, multiple funding curves, and collateral. The first part of the book assesses today's financial landscape, including the current multi-curve reality of financial markets. In mathematical but model-free terms, the second part describes all the basic elements of the pricing and hedging framework. Taking a more practical slant, the third part introduces a reduced-form modeling approach in which the risk of default of the two parties only shows up through their default intensities. The fourth part addresses counterparty risk on credit derivatives through dynamic copula models. In the fifth part, the authors present a credit migrations model that allows you to account for rating-dependent credit support annex (CSA) clauses. They also touch on nonlinear FVA computations in credit portfolio models. The final part covers classical tools from stochastic analysis and gives a brief introduction to the theory of Markov copulas.The credit crisis and ongoing European sovereign debt crisis have shown the importance of the proper assessment and management of counterparty risk. This book focuses on the interaction and possible overlap between DVA and FVA terms. It also explores the particularly challenging issue of counterparty risk in portfolio credit modeling. Primarily for researchers and graduate students in financial mathematics, the book is also suitable for financial quants, managers in banks, CVA desks, and members of supervisory bodies"--
"Preface Introduction The credit crisis and the ongoing European sovereign debt crisis have highlighted the native form of credit risk, namely counterparty risk. This is the risk of non-payment of promised cash flows due to the default of a party in an over the counter (OTC) derivative transaction. The value (price) of this risk has been initially called credit valuation adjustment (CVA), and the volatility of this value is of interest. A key related issue, especially with credit derivatives, is the so-called wrong way risk, i.e. the risk that occurs when exposure to a counterparty is adversely correlated with the credit quality of that counterparty. Moreover, as banks themselves have become risky, counterparty risk must be analyzed from the bilateral perspective: not only CVA needs to be accounted for, but also debt valuation adjustment (DVA), so that the counterparty risk of the two parties to the OTC contract are jointly accounted for in the modeling. In this context the classical assumption of a locally risk-free asset which is used for financing purposes (lending and borrowing as needed) is not sustainable anymore, which raises the companion issue of a proper accounting of the funding costs of a position (funding valuation adjustment (FVA), and liquidity valuation adjustment (LVA) when considered net of credit spread). The last related issue is that of replacement cost (RC) corresponding to the fact that at the default time of a party the valuation of the contract by the liquidator may differ from the economic value of the contract (cost of the hedge) right before that time"