Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

14.1 Background

Pricing financial instruments such as derivatives has always been relatively complex. However, certain aspects of valuation have been considered rather trivial. One of these is the use of LIBOR to discount future cash flows. In the event that these cash flows are not risk-free, CVA (or an analogous quantity) must be accounted for. The computation of CVA has been the major subject up to now in this book.

However, the traditional LIBOR discounting of risk-free cash flows, so standard for many years, requires two further assumptions for it to be valid. The first of these is that LIBOR is (or at least is a very good proxy for) the risk-free interest rate. The second is that there are no material funding considerations that need to be considered, i.e., an institution can easily borrow and lend funds at LIBOR. In the last few years both of these key assumptions have been shown to be completely incorrect. Related to these problems is the concept that the credit quality of large financial institutions is homogeneous. This is also far from true and the impact of transacting with counterparty A or counterparty B can be materially different in a number of ways.

Prior to the global financial crisis, pricing of vanilla interest rate products was understood and most attention was on exotics. Credit and liquidity were ignored, since their effects were viewed as negligible. The old-style framework for pricing financial instruments is now undergoing a revolution in order to address ...