The Valuation and Risk of OTC Derivatives

It is time to look in more detail at how OTC derivatives are valued, and how some of the risks that they create are measured and capitalised. In this chapter, the modern approach to derivatives valuation is surveyed, credit valuation adjustments are discussed, and a widely-used approach to modelling portfolio counterparty credit risk is presented. We also review some of the risks inherent in the taking of collateral, so-calle ‘credit support risks’. The situation where there is a strong (and unhelpful) association between the exposure we have and the credit quality of the counterparty is considered, and the chapter ends with an outline of how counterparty credit risk models are used by some banks to calculate regulatory capital requirements. These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.