CDSs, CVA and DVA – a structural approach

Counterparty risk is difficult to include systematically in credit default swap pricing. Reviving Merton’s structural approach – and generalising to higher dimensions – makes it tractable. By Alex Lipton and Ioana Savescu

The financial crisis has profoundly changed the nature of credit markets in general and correlation trading in particular. The focus has shifted from complicated products, such as bespoke collateralised debt obligations (CDOs) and CDOs-squared, towards simpler products, such as credit indexes and collateralised credit default swaps (CDSs), for which risks are somewhat easier to understand and model. However, as recent events have shown, the trading of even these relatively simple products can