Credit valuation adjustment
Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.
Unilateral CVA is given by the risk-neutral expectation of the discounted loss. The risk-neutral expectation can be written as
where is the maturity of the longest transaction in the portfolio, is the future value of one unit of the base currency invested today at the prevailing interest rate for maturity , is the fraction of the portfolio value that can be recovered in case of a default, is the time of default, is the exposure at time , and is the risk neutral probability of counterparty default between times and . These probabilities can be obtained from the term structure of credit default swap (CDS) spreads.
More generally CVA can refer to a few different concepts:
- The mathematical concept as defined above;
- A part of the regulatory Capital and RWA (Risk weighted asset) calculation introduced under Basel 3;
- The CVA desk of an investment bank, whose purpose is to:
- hedge for possible losses due to counterparty default;
- hedge to reduce the amount of capital required under the CVA calculation of Basel 3;
- The "CVA charge". The hedging of the CVA desk has a cost associated to it, i.e. the bank has to buy the hedging instrument. This cost is then allocated to each business line of an investment bank (usually as a contra revenue). This allocated cost is called the "CVA Charge".
Exposure, independent of counterparty default
Assuming independence between exposure and counterparty’s credit quality greatly simplifies the analysis. Under this assumption this simplifies to
where is the risk-neutral discounted expected exposure (EE)
The function of the CVA desk and implications for technology solution
||This section has been nominated to be checked for its neutrality. (July 2012)|
In the view of leading investment banks, CVA is essentially an activity carried out by both finance and a trading desk in the Front Office. Tier 1 banks either already generate counterparty EPE and ENE (expected positive/negative exposure) under the ownership of the CVA desk (although this often has another name) or plan to do so. Whilst a CVA platform is based on an exposure measurement platform, the requirements of an active CVA desk differ from those of a Risk Control group and it is not uncommon to see institutions use different systems for risk exposure management on one hand and CVA pricing and hedging on the other.
A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.
- A Guide to Modeling Counterparty Credit Risk, GARP Risk Review,July-August 2007 Related SSRN Research Paper