Discounted CF approach

Formula:

Cva dicounted cfs

 

This approach involves adjusting discount rates by including additional credit spread to the discounted projected future CFs.

These adjusted discount rates are then used to calculate FVcredit adjusted.  

Several variations of this methodology: difference being whether to use own credit spread or counterparty credit spread.

These variations include: 

a) Own/counterparty spread based on whether current MtM position is an asset or liability 

b) Own/counterparty spread based on whether each individual future CF is a net asset or liability 

c) Own/counterparty spread based on whether the cumulative net exposure at each CF date is a net asset or liability.

    Method works through CFs in chronological order 

d) as c) but method works through CFs in receding order with latest CFs first 

 

 

Advantages:

- methods (b), (c) and (d) consider bilateral nature of derivatives 

- methodology can be easily applied to most vanilla derivative valuations 

- can be applied on transaction level 

- implemented by several software vendors

 

Disadvantages: 

- does not account for potential future exposure 

- method (a) does not consider the bilateral nature of derivatives 

- not applicable to complex derivatives 

- difficult to apply at counterparty level, as this requires valuing a synthetic instrument that includes all CFs related to this counterparty.

  Exposure to a counterparty also cannot include complex derivatives 

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