CVA, DVA and Bank Earnings
Credit Value Adjustment (CVA) is the amount subtracted from the mark-to-market (MTM) value of derivative positions to account for the expected loss due to counterparty defaults. 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.

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A First View on the New CVA Risk Capital Charge

In July 2015, the Basel Committee of Banking Supervision (BCBS) published a consultative paper on credit valuation adjustment (CVA) risk to improve the current regulatory framework. In February 2016, first improvements of this framework have been introduced within the QIS instructions for the QIS based on December 2015 results.


Measurement and Management of Counterparty Risk

The measurement and management of counterparty risk is in the midst of a revolution. Within recent memory of most counterparty risk managers it all used to be so much simplier. Limits were set on the same basis as traditional lending, and the exposure measured against those limits was quantified using simple add-on factors applied to the notional of each transaction. Regulatory capital was based on the simple methodology specified under Basel I.


Comparing Alternate Methods for Calculating CVA Capital Charges Under Basel III

The global financial crisis brought counterparty credit risk and CVA very much into the spotlight. The Basel III proposals, first published in December 2009, introduced changes to the Basel II rules that reflected the need for a new capital charge against the volatility of CVA.

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