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.

CVA: Credit Value Adjustment Part 1

In coming few articles I will try to cover introduction of two most important tool of Risk Management. 

·        CVA: CREDIT VALUE ADJUSTMENT

·        VAR: VALUE AT RISK

We will start with:

CVA: CREDIT VALUE ADJUSTMENT

Summary:       After high profile bankruptcy of Lehman Brother in 2008 counterparty credit risk (CCR) measures have gained significant importance apart from traditional market risk measures. CVA, a measure of Counterparty Credit Risk, adjusts the risk free value of an instrument to incorporate counterparty credit risk. Through these series of articles I will discuss post crisis trends and developments in CVA and where it fits in the risk management systems. We will further try to explore the various approaches to CVA. We will also try to cover implication of CVA on hedging, fair pricing of trades, trading opportunities and regulatory compliances with new accounting operations.

At the end we will try to cover few case studies and examples to understand the effect of CVA in industry in more clear sense.

Introduction to Counterparty Credit Risk:             The beginning of the millennium has brought with it the worst financial crisis since the Great Depression of 1930’s. It had catastrophic effect on derivative and financial risk management. The concept of “too big to fail” failed itself with the high profile bankruptcy of Lehman Brother in 2008. The recent crisis has brought forth the importance for addressing Counterparty Credit Risk (CCR).

“CCR is the risk that counterparty in a financial contract may default prior to the expiration of the contract and fail to make future payments”.

Counterparty Credit Risk components:

Figure 1: Counterparty Credit Risk

Relative straightforward products, like credit derivatives, contain elements of CCR large enough to make the product worthless. Consequently, CCR has become an important issue for all the financial institutions, big or small. CCR gained the same status as VAR did 15 years ago, in the risk management systems of financial institutions, more so given growth of the OTC derivative market in the last decade.

In the recent scenario when the size of derivative exposure is increasing and the credit quality of counterparties is deteriorating, CCR should be addressed in more robust way.

Credit Value adjustment is the fair value of CCR. CVA adjusts the risk free value of an instrument to incorporate counterparty risk along with market risk.

                                                                                                                                  

**In next part we will be discussing in detail the definition of CVA and its evolution.

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