CVA for Bilateral Counterparty Risk under Alternative Settlement\n Conventions

We depart from the usual methods for pricing contracts with the counterparty\ncredit risk found in most of the existing literature. In effect, typically,\nthese models do not account for either systemic effects or at-first-default\ncontagion and postulate that the contract value at default equals either the\nrisk-free value or the pre-default value. We propose instead a fairly general\nframework, which allows us to perform effective Credit Value Adjustment (CVA)\ncomputations for a contract with bilateral counterparty risk in the presence of\nsystemic and wrong or right way risks. Our general methodology focuses on the\nrole of alternative settlement clauses, but it is also aimed to cover various\nfeatures of margin agreements. A comparative analysis of numerical results\nreported in the final section supports our initial conjecture that alternative\nspecifications of settlement values have a non-negligible impact on the CVA\ncomputation for contracts with bilateral counterparty risk. This emphasizes the\npractical importance of more sophisticated models that are capable of fully\nreflecting the actual features of financial contracts, as well as the influence\nof the market environment.\n