Abstract
Counterparty credit risk is basically the credit risk between over-the-counter (OTC) derivatives counterparties. Given the huge size of global OTC derivatives markets, counterparty credit risk has always be important. However, for many years before the 2007 crisis, counterparty credit risk with high rated institutions, sovereigns and collateral posting counterparties were largely underestimated or even ignored. Unfortunately, the recent crises showed that these are often the entities that represent the greatest counterparty credit risk -- think about Lehman Brothers, AIG, Bear Sterns and Greece etc. Credit Value Adjustment (CVA) is a price of cost in counterparty credit risk. It has become increasingly important for banks engaged in OTC derivatives trading. Economically, since CVA quantifies counterparty credit risk as a single, measureable, P&L number, banks are motivated in calculating CVA in order to accurately measure and properly manage their counterparty credit risk assumed. From the regulatory point of view, a capital charge for banks against CVA variability under Basel III framework comes into effect since 2013. The banks with the approval of internal model method (IMM) approach for market risk management can calculate their economic capital requirement based on the value at risk (VaR) of CVA, which can be lower than the capital charge based on the standardized approach. In this thesis, I propose a method for CVA VaR calculation based on the Jump-diffusion CIR (JCIR) hazard rate model. It is in accordance with the Basel III framework and it performs better than the historical simulation method, which is usually set as the benchmark method.