A Practical Guide to Monte Carlo CVA

Alexander Sokol

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

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

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