DVA best practises still evolving
Debt value adjustment (DVA) became a hot topic when banks announced their 3Q11 earnings, due to the magnitude and direction of the amounts reported. Best practises for pricing and hedging DVA have yet to be established, with swings in this component of bank earnings expected to continue for the foreseeable future.
Under accounting rules, DVA represents the amount added back to the mark-to-market value of a derivative exposure to account for the expected gain from a financial institution's own default. The measure has gained notoriety because it allows institutions to record gains when their credit quality deteriorates, with most banks reporting large DVA gains in Q3 due to significantly wider credit spreads.
Although banks began reporting DVA in 2007, it was really only in Q3 that the market started paying attention to it, confirms Quantifi director of research Dmitry Pugachevsky. "Compared with the previous quarter, bank credit spreads widened significantly in September on Greek rumours and European contagion. In particular, the CDS market questioned the exposure of Morgan Stanley to Italy, with its five-year spread moving from 162 in June to 492 in September. The bank's DVA number also moved because of this swing and it reported a US$3.4bn gain."
Only one bank reported a small change in DVA for the period - Goldman Sachs. This was attributed to the bank's hedging activity.
However, Pugachevsky notes that calculating and hedging DVA isn't straightforward. While there are well-established ways of hedging CVA - by buying protection on the counterparty in question - to achieve the same result for DVA, a bank would have to sell protection on itself, which is impossible.
"Alternatively, a bank could buy back some of its bonds, but they would obviously need to have issued some and this then impacts the ratio of debt and equity on their balance sheet. Consequently, most banks sell protection on a basket of proxy institutions to hedge DVA," Pugachevsky explains.
He adds: "Because of the difficulty hedging DVA, banks argue that they shouldn't have to report it. They always emphasise that it's an accounting measure and analysts tend to not to pay much attention to it."
Meanwhile, banks use credit spreads derived from their bonds - or a combination of bonds and CDS - to calculate DVA because the estimates are generally much closer than using only CDS. But using bond spreads instead of CDS seems to compromise a key benefit of including DVA in the valuation of derivative positions, according to Pugachevsky.
Please visit SCI for entire article (subscription required)