Pricing counterparty risk at the trade level and credit valuation adjustment allocations

Michael Pykhtin, Dan Rosen

Abstract

ABSTRACT

We address the problem of allocating counterparty-level credit valuation adjustment to individual trades comprising a portfolio. We show that this problem can be reduced to calculating contributions of the trades to the counterparty-level expected exposure (EE) conditional on the counterparty's default. We propose a methodology for calculating conditional EE contributions for both collateralized and non-collateralized counterparties. The calculation of EE contributions can be easily incorporated into exposure simulation processes that already exist in a financial institution. We also derive closed-form expressions for EE contributions under the assumption that trade values are normally distributed. Analytical results are obtained for the case when the trade values and the counterparty's credit quality are independent and the case when there is a dependence between them (wrong-way risk).