Back to CVA: The Case of American Option

18 Pages Posted: 7 Jun 2018 Last revised: 11 Jan 2019

Date Written: January 9, 2019

Abstract

Counterparty risk influences American option pricing in two ways. A live option suffers a credit loss upon counterparty default. The early exercise right can partially mitigate that loss. This paper proposes a model for a standalone vulnerable American put option, focusing on the early exercise boundary. The model shows precise CVA reduction mechanism afforded by the early exercise right. It demonstrates that XVA components are not additive when involving American option. It proposes a simple remedy for reducing the CVA overestimation that exists in some widely used models.

Keywords: CVA, XVA, American option, Vulnerable American option, Exercise boundary, counterparty risk

Suggested Citation

Zhou, Richard, Back to CVA: The Case of American Option (January 9, 2019). Available at SSRN: https://ssrn.com/abstract=3189805 or http://dx.doi.org/10.2139/ssrn.3189805
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