New challenges in interest rate derivatives valuation
Simple is not just simple anymore
In the past, the valuation of plain vanilla swaps has been a rather simple problem, taught in finance classrooms.
However, since the occurrence of the financial crisis, counterparty credit risk has become of paramount importance in derivatives valuation. This has led to a completely renewed valuation framework where what used to be simple has now become complex and what used to be complex is now… extremely complex.
This article deals with derivatives valuation, focusing on one of the most standard derivative contracts used in financial markets: the Interest Rate Swap (IRS). To understand how the credit crisis fundamentally affected the swaps market, it is necessary to understand how it used to work before the crisis occurred.