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Principles of Financial Engineering, 3rd Edition by Salih N. Neftci, Robert Kosowski

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Chapter 24

Counterparty Risk, Multiple Curves, CVA, DVA, and FVA

The objective of this chapter is to introduce the reader to recent innovations and market practice in financial engineering and derivatives pricing related to counterparty risk. Counterparty risk is intimately related to the cost and funding of derivatives transactions and the market maker perspective that we take throughout this book. We introduce adjustments to the default-free value of derivative contracts from the perspective of a bank to reflect the credit risk of the bank’s counterparty (credit valuation adjustment or CVA) and the own credit risk of the bank (debit valuation adjustment or DVA). CVA is shown to resemble an option on the residual value of the portfolio with a ...

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