Two identical swaps can have different economic values when their counterparties have different credit quality. The clean pricing model values promised cash flows; CVA and DVA correct for the cash flows that will actually be paid at default. Starting from the bilateral settlement ledger, this lesson derives those adjustments, computes them under an independence benchmark, and separates their signs from their economic interpretation.
Learning objectives. By the end of this note you should be able to:
- derive unilateral and bilateral valuation adjustments from close-out losses;
- distinguish a positive CVA number from its negative contribution to value;
- use expected exposure and first-default probabilities in a grid calculation;
- identify when the independence formula fails.
In this lesson
- From realised losses to a price
- Unilateral valuation and the random-maturity option
- The independence benchmark
- A complete bilateral calculation
- Interpretation and limitations
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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