Discounting and General Value Adjustment Techniques

Abstract

The collapse of Lehman has acted as a sharp reminder that financial modeling is about modeling PnL treasury shift. Indeed, holding financial products with Lehman as a counterparty can create a loss if our exposure is positive to Lehman at the time of default. This situation has created the need to follow the CVA (credit value adjustment — a measure of counterparty risk). How much should I adjust my price to reflect the possibility of my counterparty defaulting? There is also a symmetrical notion that is the DVA (debit value adjustment) which constitutes the answer to the damage my own default can create for my counterparties.