Journal of Computational Finance

Evaluating credit valuation adjustment with wrong-way risk for Bermudan options

Bing Dong, Wei Xu and Guangguang Wang

  • We present an algorithm designed for the calculation of Credit Value Adjustment (CVA) for a Bermudan put option within the framework of intensity rate and jump-at-default wrong way risk models, utilizing the willow tree structure.
  • Our approach accommodates both the direct definition of CVA and the indirect definition based on the fundamental mathematical expression of CVA.
  • Diverging from a singular point estimation of CVA at inception, our method provides a range of CVA values for the Bermudan option, considering variations in underlying asset prices and time to maturity.

Calculating the credit valuation adjustment (CVA) of a Bermudan option with wrong-way risk is computationally challenging because of the highly demanding simulations and the presence of two stopping times: the counterparty default time and the optimal early exercise time. In this paper we propose an efficient and accurate numerical framework for CVA evaluation that fully avoids simulations, with the wrong-way risk tracked by both the intensity rate model and the jump-at-default model. The optimal exercise boundary impacted by the counterparty credit risk can also be determined under the same framework. Our method therefore provides a proxy that can aid regulatory frameworks and allow option pricing and CVA quotes to be executed on the same platform.

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