# Swaption Approach

Formula:

The swaption approach models EPE as a series of swaptions and is only applicable where the derivative is an IR swap.

Simplistically, the exposure is modelled as:

- an option on a reversed swap in case the counterparty defaults before the first CF date +

- + an option on the reversed swap excluding the first CF in case the counterparty defaults between the first and second CF dates

- etc...

The number of swaptions is determined by the remaining term of the contract and the payment frequency.

Terms:

Swaptiont = fair value of an option with expiry t on a swap opposite to the derivative, with maturity T – t.

PD(t-1, t) = probability of default between time t – 1 and t.

The CVA calculation utilises counterparty PDs, while for DVA own PDs are used.

- methodology takes both current and potential future exposure into account

- considers bilateral nature of derivatives

- can be applied on transactional level

- terms of swaptions are easy to determine

- intuitive appeal as the CVA is based on the cost of replacing the asset

- applies to IR swap exposures only

- difficulty to apply on counterparty level, especially when exposure to counterparty includes derivatives other than IR swap.

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