Valuing Non-collateralized Swaps with Adjustments

Since the Global Financial Crisis of 2008, major financial supervisory institutions have initiated regulatory measures to mitigate counterparty default risks in the swap market. Currently, the collateralized swaps are traded as the market standard in the rules of CCP clearing and Global Margin. Nonetheless, the non-collateralized swaps are still traded. In case the foreign swap dealers enter into swaps without collaterals, they adjust swap values that are obtained by the OIS discounting, where hedging costs from credit default and funding risks are added back or subtracted, and transferred to non-collateralized counterparties. This process is called the valuation adjustment that consists of CVA, DVA and FVA. In the overseas swap market, the valuation adjustment has already become the market convention. However, in the domestic swap market, its necessity has not even been highlighted. Also the domestic swap dealers remain at a very low level of understanding and interest of the valuation adjustment. This research intends to show that the omission of valuation adjustment will cause issues of fair value pricing and risk management, going through cash flow estimation by Ho-Lee and KWF model for swap portfolio and calculation of CVA, DVA and FVA, and deliver the specific implications of valuation adjustment to the domestic swap market by identifying disputed points around the methodology of valuation adjustment that is widely adopted in the overseas swap market.