The impact of credit spreads on US bank earnings has become so volatile that it is causing a rethink of derivatives valuations. Last month’s earnings releases revealed such sharp swings from Q3 to Q4 and on a year-on-year basis that banks either reported some of their worst earnings results or they managed to hold their own, depending on which accounting numbers are used.
Bank risk managers are still having a hard time grasping credit valuation adjustment (CVA), which discounts the value of derivatives positions to account for the expected loss due to counterparty defaults, let alone debt valuation adjustment (DVA), which is the amount added back to the derivatives position to account for the expected gain from a firm’s own default.
Banks are now discussing a way to price liquidity risk that would take the difference between DVA calculated with credit default swap spreads and DVA calculated with bond spreads, according to Dmitry Pugachevsky, director of research at software and analytics provider Quantifi. Liquidity valuation adjustment is considered a more accurate measure of pricing liquidity risk.
LVA could present its own “asymmetric pricing problem”, added Pugachevsky, but the valuation could also offset some of the recent widening in the bond-CDS basis.
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