Penalty methods for bilateral XVA pricing in European and American contingent claims by a partial differential equation model

Yuwei Chen and Christina C. Christara

Abstract

Accounting for default risk in the valuation of financial derivatives has become increasingly important, especially since the 2007–8 financial crisis. Under some assumptions, the valuation of financial derivatives, including a value adjustment to account for default risk (the so-called XVA), gives rise to a nonlinear partial differential equation (PDE). We propose numerical methods for handling the nonlinearity in this PDE, the most efficient of which are the discrete penalty iteration methods. We first formulate a penalty iteration method for the case of European contingent claims and study its convergence. We then extend the method to the case of American contingent claims, which results in a double-penalty iteration. We also propose boundary conditions and their discretization for the XVA PDE problem in the case of a call option, a put option and a forward contract. Numerical results demonstrate the effectiveness of our methods.