Counterparty Risk FAQ: Credit VaR, PFE, CVA, DVA, Closeout, Netting, Collateral, Re-Hypothecation, WWR, Basel, Funding, CCDS and Margin Lending by Damiano Brigo :: SSRN: a dialogue on Counterparty Credit Risk touching on Credit Value at Risk (Credit VaR), Potential Future Exposure (PFE), Expected Exposure (EE), Expected Positive Exposure (EPE), Credit Valuation Adjustment (CVA), Debit Valuation Adjustment (DVA), DVA Hedging, Closeout conventions, Netting clauses, Collateral modeling, Gap Risk, Re-hypothecation, Wrong Way Risk, Basel III, inclusion of Funding costs, First to Default risk, Contingent Credit Default Swaps (CCDS) and CVA restructuring possibilities through margin lending. The dialogue is in the form of a Q&A between a CVA expert and a newly hired colleague.
A rather long look in:
"Q: Fine. How is Credit VaR typically calculated?
A: Credit VaR is calculated through a simulation of the basic financial variables underlying the portfolio under the historical probability mea- sure, commonly referred as P, up to the risk horizon. The simulation also includes the default of the counterparties. At the risk horizon, the portfolio is priced in every simulated scenario of the basic financial variables, including defaults, obtaining a number of scenarios for the portfolio value at the risk horizon.
Q: So if the risk horizon is one year, we obtain a number of scenarios for what will be the value of the portfolio in one year, based on the eve- olution of the underlying market variables and on the possible default of the counterparties.
A: Precisely. A distribution of the losses of the portfolio is built based on these scenarios of portfolio values. When we say ”priced” we mean to say that the discounted future cash flows of the portfolio after the risk horizon are averaged conditional on each scenario at the risk horizon but under another probability measure, the Pricing measure, or Risk Neutral measure, or Equivalent Martingale Measure if you want to go technical...
Good stuff although I doubt it will be coming to a stage near you soon.