Discounted CF approach

Formula:

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 FV_{credit 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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