Fair value of a swap: CVA and DVA. A binomial approximation

Abstract

According to IFRS 13, in force in Spain since January 1, 2013, credit risk adjustments must be made in the value of financial derivatives to obtain their fair value, which is necessary, from an accounting point of view, for financial entities and those that apply the PGC 1514/2007.

This work obtains the fair value of a generic interest rate swap . The CVA or negative adjustment for default risk of the counterparty is deducted from its risk-free value and the DVA is added , which is the positive provision for the default risk of the entity itself.

To calculate the CVA / DVA, it is necessary to know the expected exposure of the swap, which is obtained from a binomial model of forward interest rates, and to determine the probabilities of default, which are obtained from corporate bond credit spreads