What is CVA?
Credit Valuation Adjustment (CVA) is the price that an investor would pay to hedge the counterparty credit risk of a derivative instrument. It reduces the mark to the market value of an asset by the value of the CVA.
CVA is the most widely known of the valuation adjustments, collectively known as XVA.
History
Credit Valuation Adjustment was introduced as a new requirement for fair value accounting during the 2007/08 Global Financial Crisis. CVA has attracted much attention among derivative market participants and most of them have incorporated CVA in deal pricing.
The concept of credit risk management, which includes credit valuation adjustment, was developed due to the increased number of country and corporate defaults and financial fallouts.
The Credit Value Adjustment is by definition the difference between the risk-free portfolio and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA represents the market value of the counterparty credit risk.
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CVA Vs Credit Limit?
- Traditional counterparty risk management works in a binary fashion. The use of credit limits, for example, gives an institution the ability to decide whether to enter into a new transaction with a given counterparty. If there were a breach of the credit limit then a transaction would be refused (except in special cases).
- The problem with this is that the risk of a new transaction is the only consideration whereas the return (profit) should surely be a factor also.
- The question of whether to do a transaction becomes simply whether or not it is profitable once the counterparty risk component has been “priced in.”
Broadly speaking, there should be three levels to assess the counterparty risk of a transaction:
Trade level. Incorporating all characteristics of the trade and associated risk factors. This defines the counterparty risk of a trade at a “stand-alone” level.
Counterparty level. Incorporating the impact of risk mitigants such as netting and collateral for each counterparty (or netting set) individually. This defines the incremental impact that trade has with respect to existing transactions.
Portfolio level. Consideration of the risk to all counterparties, knowing that only a small fraction may default in a given time period. This defines the impact trade has on the total counterparty risk faced by an institution.
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What is (XCVA)?
XCVA is an extension of the better-known credit valuation adjustment (CVA), which is used to hedge against a bank’s aggregated counterparty risk. XCVA covers all derivatives valuation adjustments, including debit valuation adjustment (DVA) and fund valuation adjustment (FVA).
XCVA, or X-Value Adjustment, is a collective term that covers the different types of valuation adjustments relating to derivative contracts. The adjustments are made to account for the account funding, credit risk, and capital costs.
When initiating new trades in the derivatives market, traders incorporate XCVA into the price of the derivative instrument.
It stands for X-Value Adjustment and is used in financial valuation models. It’s a generic term referring to a number of different valuation adjustments in relation to derivatives, such as options and futures, held by investment banks.
Different Components of CVA
CVA and DVA. Defines the bilateral valuation of counterparty risk. DVA (debt value adjustment) represents counterparty risk from the point of view of a party’s own default
FVA. Defines the cost and benefit arising from the funding of the transaction.
ColVA. Defines the costs and benefits from embedded optionality in the collateral agreement (such as being able to choose the currency or type of collateral to post), and any other non-standard collateral terms (compared to the idealized starting point
KVA. Defines the cost of holding capital (typically regulatory) over the lifetime of the transaction.
MVA. Defines the cost of posting initial margin over the lifetime of the transaction.
Challenges
While a small number of banks are prepared for the regulatory changes and are actively managing CVA, the complexity and cost of implementing the necessary infrastructure remain a big job for the majority.
Common challenges for all entities computing CVA is obtaining the necessary market data required for the calculation and the expected exposure.
At an operational level at banks, the challenges of XCVA are deeper. XCVA implementation is requiring an operating model change to traditional front office trading operations, and significant investment in IT infrastructure is required to assist Finance, Risk, and Operations functions with the change.
Author: Deepika
About the Author: Deepika is professionally qualified as CFA Chartered ( ICFAI University. She is currently pursuing GARP FRM Certification and associated with NSDL Payments Bank as an Assistant Manager in the Risk Management domain.
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