TriOptima: Hedging error in CVA
Posted: 12 September 2018 | Source: TriOptima
The Probability Matrix Method, used to model Counterparty Credit Risk (CCR), relies on common transition probability matrices for generating scenarios and pricing netting sets. This allows the use of consistent models for simulation and pricing when computing and hedging X-Value Adjustments (XVA). Traditional XVA systems separate instead the tasks of generating market factor paths and pricing netting set values. The pricing models generally imply a different dynamic behaviour of the underlying from the one assumed by the simulation model in the path generation phase. For valuation adjustments, such as the Credit Value Adjustment (CVA), this mismatch leads to incorrect valuation of risk metrics and to incorrect hedging strategies for risk management. The aim of this paper is to investigate the hedging error in CVA produced by using a model for the simulation of the risk factors different from the one used in the pricing of the derivative contract.