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From the Desks of Professors John Hull & Alan White: Valuation Adjustments 1

World-renowned Professor John Hull, Maple Financial Professor of Derivatives and Risk Management at the Rotman School of Management, University of Toronto is also Co-Director of our Master of Financial Risk Management program.

Here is a portion of a blog post that Professor Hull and Professor Alan White recently wrote on derivative valuation that may be of interest to you. Professor White is known for work including the Hull-White interest rate model. Both Professors teach in the MFRM program. This is a taste of the kind of industry and research thought leadership that you expect to experience in the MFRM program.

Valuation Adjustments 1

Valuing derivatives used to be much simpler than it is today. For example, an interest rate swap could be valued by knowing nothing more than forward LIBOR rates. An interest rate cap could be valued by modeling the LIBOR short rate.  Now, as explained in an earlier blog, it is necessary to worry about the behavior of OIS rates as well as LIBOR because OIS is generally accepted as being the correct discount rate for fully collateralized transactions.

Valuation complications are also created by what are known as valuation adjustments, the XVAs. These are adjustments to the valuation given by a basic model, for example the Black-Scholes-Merton model.  In this blog we will discuss the credit valuation adjustment (CVA) and debit (or debt) valuation adjustment (DVA). Other valuation adjustments, specifically FVA, MVA, and KVA, will be covered in future blogs.

The credit valuation adjustment, CVA, has been recognized as an important element of pricing for a long time. It is the downward adjustment to the value of a derivative in a bilaterally cleared transaction because of the possibility that the counterparty will default. Because bilaterally cleared transactions are almost invariably governed by a master agreement that includes netting, the expected loss from a default by a particular counterparty depends on the whole portfolio of transactions a dealer has with a counterparty. It cannot be calculated on a transaction-by-transaction basis.

The CVA applied to a new transaction should in theory equal the incremental effect of the new transaction on the CVA for the portfolio of transactions with the counterparty. This can be positive or negative. If the value of the new transaction at future times is positively correlated with the total value of the other transactions in the portfolio, the incremental effect is likely to be positive. If it is negatively correlated with the total value of the other transactions, the incremental effect is likely to…

To read the rest of this blog post, visit the FINCAD blog.

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