Credit Value Adjustment: Comparison between constant and dynamic market-implied recovery

Details

Supervisors

Vrins, Frédéric

Faculty

Louvain School of Management

Degree label

Master [120] en ingénieur de gestion

Abstract

The 2008 financial crisis highlighted the flaws in the system regarding counterparty risk. The assessment of credit quality mainly relied on credit ratings provided by special- ized agencies but with restricted accuracy. In this submission we develop the credit value adjustment model proposed by the Basel Committee to consider counterparty credit risk in estimating the value of a derivative. Different approaches existing, we decide to address the following problematic: what is the impact of a market-implied recovery on the CVA compared to a constant recovery rate? Our first practical approach considers the recovery rate, one of the components of the model, to be constant. While this limitation facilitates the CVA calculations, it under- estimates the accuracy of the actual amount to be added to the value of the security. To counter this problem, we compare our results with a model whose recovery is implicit to the market and is now dynamic. Considering two financial counterparties, namely Morgan Stanley and the Deutsche Bank, we observe that for a very short maturity, the first model overvalues the CVA for two good credit-quality institutions. However, for a longer term of one or two years, our second model provides an adjustment that is almost twice that obtained for a constant recovery rate.