Evaluation of counterparty credit risk under netting agreements

We investigate counterparty credit risk and credit valuation adjustments in portfolios including derivatives with early-exercise opportunities, under a netting agreement. We show that credit risk and netting agreements have a significant impact on the way portfolios are managed (that is, on options’ exercise strategies) and, therefore, on the value of the portfolio and on the price of counterparty risk. We derive the value of a netted portfolio as the solution of a zero-sum, finite horizon, discrete-time stochastic game. We show that this dynamic-game interpretation can be used to determine the value of the reglementary capital charges required of financial institutions to cover for counterparty credit risk and we propose a numerical valuation method. Numerical investigations show that currently used numerical approaches can grossly misestimate the value of credit valuation adjustments. • We compute the CVA of netted portfolio including early-exercise opportunities. • The portfolio is evaluated via a zero-sum finite horizon stochastic game. • Netting and credit risk impact the exercise strategies of counterparties. • Netting and credit risk modify the CVA. • We analyze the sensitivity of exercise strategies to portfolio and risk parameters.