A Practical Guide to Monte Carlo CVA

Alexander Sokol

The regulatory and internal requirement to measure counterparty risk pre-dates the financial crisis by many years. Most firms carrying derivatives books had the ability to compute counterparty exposures for their trades, and many had built sophisticated Monte Carlo systems to do so. The only thing that was missing was taking the possibility of default seriously. Because of the perceived low probability of default, enormous exposures were allowed to build up at some firms without raising any alarms. For the same reason, the information on exposures available to market participants prior to the crisis was often not used to mitigate counterparty risk despite the low cost of credit insurance in pre-crisis years.

The financial crisis brought new urgency to the efforts in implementing calculation of potential future exposure (PFE) and credit value adjustment (CVA). Having seen the default of Lehman Brothers, and near default of other firms, the market participants were for the first time taking seriously the risk of default and assigning a more realistic probability to it, as evidenced by the dramatic widening of credit spreads during and immediately after the crisis. The increased