A protection buyer can lose money because the reference company defaults, because its protection seller fails, or because its own bank fails first. These are different events with different cash flows. Confusing them leads to double-counted defaults and the wrong sign for CVA and DVA. This lesson builds the event ledger that must precede any counterparty pricing engine.
Learning objectives. By the end of this note you should be able to:
- distinguish investor, counterparty and reference-entity defaults;
- derive each close-out payment from signed clean value;
- calculate first-to-default probabilities in an independent constant-intensity benchmark;
- explain why subtracting two unilateral adjustments is generally not bilateral valuation.
In this lesson
- Three names, three economic jobs
- The first event stops the single-contract calculation
- Derive the close-out cash flows
- An exact first-to-default benchmark
- Why two unilateral numbers do not solve the problem
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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