CVA, DVA and Hedging Earnings Volatility

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. Debt Value Adjustment (DVA) is basically 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 theoretically report the same credit-adjusted MTM value. DVA is also controversial because institutions record gains when their credit quality deteriorates, creating perverse incentives, and the gains can only be realised on default.

Accounting rules mandate the inclusion of CVA in MTM reporting, which means bank earnings are subject to CVA volatility. DVA is also accepted under the accounting rules and banks that include it, and by doing so must continue to include it going forward, add their own credit spread as a source of earnings volatility. To mitigate CVA volatility, as well as hedge default risk, many banks buy CDS protection on their counterparties. Hedging DVA is not as straightforward. Since DVA increases as the bank’s credit spread widens, it is equivalent to the bank being short its own debt. Therefore, hedging involves buying the bank’s own bonds or selling protection on highly correlated institutions, i.e., other banks, since they can’t sell protection on themselves.

DVA became a hot topic when banks announced 2011 Q3 earnings, due to the magnitude and direction of the amounts. Ironically, where large DVA gains substantially impacted earnings, the bank’s outlook improved, thereby tightening its credit spread and generating DVA losses. This paper is a sequel to a previous report entitled ‘CVA, DVA and Bank Earnings’, which attempted to dissect the Q3 DVA results and make some predictions about Q4. This paper will analyze the recently reported Q4 DVA results.

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