CVA: CREDIT VALUE ADJUSTMENT Part 2

EVOLUTION OF CVA: Find below the time line giving major milestones in the evolution of CVA:

CVA Definition:

In simple terms CVA is measure of counterparty default risk, accounting for the cost of carry and hedging the risk. It is the difference between the values of the risk free derivative portfolio and a true portfolio that accounts for the possibility of counterparty default.

CVA can be expressed as:

“CVA = Risk free value of derivative – Risky value of a derivative”

*Risk corresponds to only credit risk. (Probability that counterparty will default).

CVA can be categorized into two parts:

1. Asset CVA (Commonly referred as CVA): It is measure of risk pertaining to counterparty- default with negative exposure on deal. As in this case, the instrument holder with positive exposure will have to bear loss, hence leading to downgrade adjustment in the instrument’s value.
2. Liability CVA (Commonly referred as DVA): As name suggests this is exactly opposite of Asset CVA. Many institutions fail to recognize the case where they themselves may default. In above mentioned case, if institution is having negative exposure, it will be defaulting on its liability. Thus DVA leads to upgrade in valuation of underlying instrument.

*DVA will be discussed later with case study of Citi Bank where they reported huge profit based on taking DVA into accounting.

Important Properties:

1. Two-third of Counterparty Credit Risk losses are due to CVA losses and only one-third are due to actual defaults. (BASEL committee, 2009)
2. CVA is an integral part of instrument valuation but it cannot be determined at instrument or trade level. To determine CVA for instrument, we need to consider marginal CCR by instrument on portfolio including netting effect.