The book provides an analytical basis for the quantitative methodology of dynamic valuation, mitigation and hedging of bilateral counterparty risk on OTC derivative contracts under funding constraints. The counterparty risk concerns two parties called the bank and its counterparty. Even if in general this term applies to both parties, in the corresponding financial transactions it is analyzed mainly from the perspective of the bank throughout the book. The authors review cunterparty risk in its different aspects such as CVA (Credit Valuation Adjustment), DVA (Debt Valuation Adjustment), FVA (Funding Valuation Adjustment), LVA (Liquidity Valuation Adjustment), RC (Replacement Cost), RVA (Rating Valuation Adjustment), TVA (Total Valuation Adjustment), wrong-way risk, multiple funding curves and collaterals.
The book is intended primarily for researchers and graduate students in financial mathematics but also to analysts and managers in banks, CVA desks and to members of the supervisory bodies. The two puzzles in the title of the book are (1) the DVA/FVA puzzle regarding the interaction and possible overlap between DVA (own credit) and FVA (funding), and (2) the top-down versus bottom-up portfolio credit modeling puzzle.
The content of the book is as follows: Part I sets the “financial landscape” (1. A Galilean dialogue on the counterparty risk, CVA, DVA, multiple curves, collateral and funding; 2. The whys of the LOIS (i.e. LIBOR Overnight Index Swap)); Part II describes in mathematical but model-free terms the basic elements of the corresponding pricing and hedging framework (3. Pure counterparty risk; 4. Bilateral counterparty risk under funding constraints); Part III specifies the setup for a reduced-form BSDE modeling (i.e. Backward Stochastic Differential Equations) (5. A reduced-form TVA BSDE approach to counterparty risk under funding constraints; 6. The four wings of TVA); Part IV treats the dynamic copula models (7. Dynamic Gaussian copula models; 8. Common-shock model; 9. CVA computations for one CDS in the common-shock model; 10. CVA computations for credit portfolios in the common-shock model); Part V indicates further developments (11. Rating triggers and credit migrations; 12. A unified perspective); Part VI is the mathematical appendix (13. Stochastic analysis prerequisites; 14. Markov consistency and Markov copulas).