CVA is easy to understand in the context of a loan – it is the loan principal, minus anticipated recovery, multiplied by the counterparty’s default probability over the term of the loan. For derivatives, the loan amount is the net MTM value of derivative positions with that counterparty.
Calculating CVA for derivatives is complex because the MTM value changes through time depending on the path of the underlying market rates, such as interest rates, FX rates, commodity prices, etc. Since the MTM value can fluctuate in either party’s favour, both institutions may be exposed to default risk. To compound the complexity, the counterparty’s default probability, typically implied from credit spreads, may be correlated to the other market risk factors.
Debt Value Adjustment (DVA) is simply CVA from the counterparty’s perspective. If one party incurs a CVA loss, the other party records a corresponding DVA gain. DVA is the amount added back to the MTM value to account for the expected gain from an institution’s own default. Including DVA (in addition to CVA) is intuitively pleasing because both parties report the same credit-adjusted MTM value. DVA is also controversial because institutions record gains when their credit quality deteriorates, creating perverse incentives, and these gains can only be realized on default.
Most of the concepts summarised above recently drew attention when banks announced third quarter earnings. This paper highlights some of the results reported by larger banks and potential implications going forward.
