Credit Valuation Adjustment

What Is Credit Valuation Adjustment (CVA)?

Credit valuation adjustment or CVA refers to the market value of the counterparty credit risk arising due to the failure of a party to fulfill their financial obligation typically mentioned in a derivative contract. It helps one determine the difference between true and risk-free portfolio values.

A CVA considers market risk factors and the counterparty credit spread, which one can obtain by computing the difference between the profits of two bonds with different credit quality but similar maturity. This accounting adjustment decreases an asset’s mark to market or MTM value by the CVA value. It is applied to all OTC (over-the-counter) capital market products.

• Credit valuation adjustment (CVA) refers to an adjustment made to the valuation of a portfolio or any derivative instrument to reflect the counterparty credit risk.
• A key difference between credit valuation adjustment and debit valuation adjustment is that the former is positive while the latter is negative.
• There are multiple misperceptions of CVA. A noteworthy one is that its computation is fully separate from the contract exposure calculation.
• The credit valuation adjustment calculation can help individuals find the difference between risk-free and true portfolio values.

Credit Valuation Adjustment Explained

The credit valuation adjustment refers to the price of the default risk for a portfolio comprising derivatives or a single derivative with a specific counterparty taking into account the impact of offsetting collateral. The concept came into existence during the 2007-2008 financial crisis. Post-introduction, various derivatives market participants found it enticing. Moreover, many individuals incorporated the accounting adjustment in deal pricing.

This concept’s development occurred due to increased financial fallouts and corporate and national defaults. Before the global financial crisis (GFC), market participants assumed that the large derivative counterparties could not default. That said, multiple corporate collapses occurred during the GFC, and derivative counterparties failed to fulfill their financial obligations. Hence, the market participants began incorporating CVA while computing OTC derivative instruments’ value.

The CVA methods that individuals can utilize are as follows:

#1 - Simulation Modelling

This technique involves simulating the risk factor and market risk factor scenarios. Then, the revaluation of the derivatives takes place through the utilization of different simulation scenarios. Each counterparty’s expected exposure profile is determined by aggregating the matrix product. Every counterparty’s anticipated exposure is subject to adjustment for obtaining the collateralized anticipated exposure profile.

#2 - Swaption-Type Valuation

This CVA valuation methodology requires access to certain market data and advanced knowledge regarding derivative valuations. In addition, this technique involves utilizing counterparty credit spread to project the asset’s replacement value.

#3 - Simple Approach

It computes the instrument’s MTM value. Then, it repeats the calculation to adjust the discount rates by the credit spread of the counterparty. After that, one must find the difference between the two values obtained to determine CVA.

Formula

One can use the following formula for credit valuation adjustment:

Where:

T = The longest transaction’s maturity period

R = The fraction of the portfolio’s value that one can eliminate in the case of default

T = Time of default 

E(t) = The Exposure at T

B_t = Future per value unit value of the base currency allocated at the current rate of interest at T maturity

dPD(0,t) = Counterparty default’s risk-neutral probability (between times s and t)

Examples

Let us look at a few credit valuation adjustment examples to understand the concept better.

Example #1

In the last week of September 2022, banks faced significant losses on uncollateralized derivatives. This was because the wild moves in sterling and gilt led to a rise in the counterparty risk. Moreover, the increased funding costs of trade with United Kingdom corporates were an important factor.

A major portion of the pain resulted from a surge in counterparty exposures, which led to the so-called CVA losses. An individual engaging in derivatives trading at a U.S. bank said that their CVA exposures to the U.K. corporates shot up by ‘hundreds of millions’ when the market was in turmoil.

Example #2

In 2020 the Basal Committee on Banking Supervision, or BCBS, published a new standard concerning the regulatory capital treatment of CVA risk for securities and derivatives financing transactions. The revisions were as follows:

• Different treatment of specific client-cleared derivatives
• Recalibrated risk weights
• An overall recalibration concerning the basic and standard approach.

Misperceptions

• The counterparty default risk does not exist owing to the Dodd-Frank Central clearing mandate.
• If a swap is an asset to an organization, then the other party’s default risk will be taken into consideration only.
• The credit valuation adjustment calculation is completely separate from the calculation of the contract exposure.
• CVA computation is a static DCF or discounted cash flow kind of analysis.
• The effects of default probability on swap valuations are minimal, almost always.

Credit Valuation Adjustment vs Debit Valuation Adjustment

Understanding the meaning of credit value adjustment and debit value adjustment for anyone new to the finance world can be challenging. The two concepts can create confusion among such individuals. That said, one must know how they differ to understand the concepts fully and avoid confusion. Hence, the table below shows their differences.

Credit Value Adjustment	Debit Value Adjustment
This refers to the price investors pay to hedge a derivative instrument’s counterparty credit risk.	It reflects the credit risk of the bank that writes the contract.
The CVA is a positive amount. Hence, one must subtract it from the risk-free net present value or NPV.	The digital value adjustment or DVA amount is negative. Therefore, one must add DVA’s absolute value to the risk-free net present value.

Frequently Asked Questions (FAQs)

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