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2.3 CONTINGENT CDS PRICING AND CVA

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Encouraged by the successful migration of a large number of trades away from Monte Carlo models to more efficient analytic models, attention falls on a portfolio of contingent CDS trades offering counterparty default protection on interest rate (including cross‐currency) underlyings. Calculations for these are known to be very expensive on account of the need to integrate contributions from all possible default times in the exposure period, which requires in turn calculation of the value of the swap underlying at each such time for each Monte Carlo path. It is noted that analytic formulae for calculation of such protection are provided in §9.3.5 for single‐currency interest rate swaps and in §10.4 and §12.4 for cross‐currency swaps. The formulae are implemented and it is found that substantial speed‐up is achieve in pricing, and particularly in risk‐managing these trades.

The CVA desk hear about this and note that the CVA calculations they perform on interest rate portfolios are closely related to the contingent CDS protection pricing problem. They start looking into whether they could incorporate a similar analytic pricing approach into their workflow.

Perturbation Methods in Credit Derivatives

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