Counterparty Credit Exposures for Interest Rate Derivatives using Stochastic Grid Bundling Method and Change of Measure

Abstract: The notional amounts outstanding of over-the-counter (OTC) derivatives had grown exponentially for almost two decades and its rapid growth were mainly due the increase in OTC interest rate derivatives. As of december 2014, the total notional amounts outstanding in the global OTC market was 630 trillions USD and the OTC interest rate derivatives represents about 80% of the market. Trading with OTC derivatives can lead to signicant risks. Especially counterparty credit risk has gained particular emphasis due to the credit crisis in 2007. The aim of this thesis is to determine if it is possible to get realistic estimations of counterparty credit risk measures as Expected Exposure (EE) and Potential Future Exposure (PFE) that re ects the "real world" market. In order to do simulations under the historical P-measure, attempts are made to approximate the market price of risk and then calculate exposure proles for the interest rate derivative Bermudan swaption. The Hull and White one-factor short rate model is used and all calculations are done using the Stochastic Grid Bundling Method(SGBM).