This week’s Learning Curve was written by David Kelly, Director of Credit Products, and Dmitry Pugachevsky, Director of Research, at Quantifi.
Credit value adjustment 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 less anticipated recovery, times 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 and commodity prices. Since the MTM value can fluctuate in either party’s favor, both institutions may be exposed to default risk. To compound the complexity, the counterparty’s default probability, typically implied from credit spreads - and the recovery rate, typically assumed fixed -, may be correlated to the other market risk factors.
Debt value adjustment 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 in the event of a default.
Accounting rules mandate the inclusion of CVA in MTM reporting - IAS 39 (2005) and FAS 157 (2007)—which means bank earnings are subject to CVA volatility. To mitigate CVA volatility, as well as hedge default risk, many banks buy credit default swap (CDS) protection on their counterparties. Some banks further stabilize CVA by hedging the other market risk factors that affect CVA through the MTM value.
Most of the concepts summarized above recently drew attention when banks announced third quarter earnings. This Learning Curve highlights some of the results reported by larger banks and potential implications going forward.