2018/08/14 by Maxim Bichuch, Bichuch, Maxim, Agostino Capponi +3
Business, Management and Accounting · Decision Sciences · Economics, Econometrics and Finance · #Credit Risk and Financial Regulations #FOS: Economics and business #Financial Distress and Bankruptcy Prediction #Pricing of Securities (q-fin.PR) #Risk and Portfolio Optimization
paper · pdf · doi:10.48550/arxiv.1808.04908
openalex publication_date 2018/08/14 · openalex created_date 2024/04/11 · openalex updated_date 2026/07/28
We introduce an arbitrage-free framework for robust valuation adjustments. An investor trades a credit default swap portfolio with a risky counterparty, and hedges credit risk by taking a position in defaultable bonds. The investor does not know the return rate of her counterparty's bond, but is confident that it lies within an uncertainty interval. We derive both upper and lower bounds for the XVA process of the portfolio, and show that these bounds may be recovered as solutions of nonlinear ordinary differential equations. The presence of collateralization and closeout payoffs leads to important differences with respect to classical credit risk valuation. The value of the super-replicating portfolio cannot be directly obtained by plugging one of the extremes of the uncertainty interval in the valuation equation, but rather depends on the relation between the XVA replicating portfolio and the close-out value throughout the life of the transaction. Our comparative statics analysis indicates that credit contagion has a nonlinear effect on the replication strategies and on the XVA.