What Is Credit Valuation Adjustment?


Author: Albert
Published: 3 Nov 2021

Swaption-type credit valuation

If a counterparty defaults on their financial obligations, exposure to loss occurs for a unilateral derivative instrument holder. The amount of loss that an investor incurs is the same as the fair value of the instrument at the time of default. The swaption-type is a more complex credit valuation adjustment methodology that requires advanced knowledge of derivatives and access to market data. The replacement value of the asset is estimated using the credit spread.

CVA desk: A hedge against default in the credit default swaps market

CVA desk buys protection against default from the credit default swaps market. If the desk can't get liquid contracts for certain parties, it may enter into an approximate hedge by buying credit protection and increasing the fees charged to the trading desk.

The third argument: Self-default on derivative obligations

The third argument is that if there was a self-default on the derivative obligation, the amount that could be recovered would be the only amount paid. The amount written off can be seen as a benefit to the bondholders. The capital that banks must hold against their derivatives is mandated by the regulation. The cost of holding the regulatory capital against a trade is encapsulated by the KVA and is very hard to estimate and varies from one regulatory environment to another.

Valuation Adjustment: A Differential Approach across Banks

Valuation adjustment is the umbrella name for the adjustments made to the fair value of a derivatives contract to take into account funding, credit risk and regulatory capital costs. The costs associated with XVAs are typically included in the price of a new trade. Depending on their calculation methodology and portfolio, XVA calculations can differ across banks. Smaller banks do not charge clients for some elements.

XVA: Valuation Adjustments for Derivative Contracts

XVA is a collective term that covers different types of valuation adjustments for derivative contracts. The account funding, credit risk, and capital costs are all taken into account. XVA is incorporated into the price of the derivative instrument when new trades are initiated.

A CVA desk is created in the trading desk of tier one investment banks. The secret to running a CVA desk is to strike a balance between taking risks and hedging them. The desk hedges for potential losses.

The capital required under the calculation is reduced. The funding benefit adjustment occurs when the bank acquires a liability position. A bank buys a negative market value derivative in exchange for cash.

The cash can be invested in ventures that make money. External funding can be costly for a company if the bank resorts to it. It is different from funding benefit adjustment.

A funding cost adjustment is caused when a bank acquires a derivative. The bank pays cash for the asset position derivative. The cost of the purchase is seen as a way of raising money for investment.

Credit Valuation Adjustment and the Impact of a New Transaction

It used to be simpler to value derivatives. An interest rate swap could be valued by knowing the forward rates. The interest rate cap could be valued by modeling the short rate.

OIS is the correct discount rate for fully collateralized transactions, so it is important to worry about the behavior of OIS rates. The credit valuation adjustment, CVA, has been an important part of pricing for a long time. The downward adjustment to the value of a derivative is made because of the possibility that the other party will default.

The expected loss from a default by a particular counterparty depends on the whole portfolio of transactions a dealer has with that particular person. It can't be calculated on a transaction-by-transaction basis. The results of the most recent CVA calculation can be used to estimate the impact of a new transaction.

The values for the portfolio and the paths followed by the market variables are stored. The new transaction can be modeled on its own using the stored paths for the market variables and the effect on the vi is calculated relatively quickly. It is not necessary to re-simulate the other transactions.

Hedging a Product

It's not possible to derive a hedging strategy just by looking at the CVA figure, it's like asking what the hedging strategy of a product is if it's worth 1 million dollars. You need the CVA greeks.

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