CVA desks have been developed in response to crisis-driven regulations for improved counterparty risk management. How do these centralized groups differ from traditional approaches to manage counterparty risk, and what types of data and analytical challenges do they face?
RESOURCES
Whitepapers and articles providing insight on key topics related to the financial markets.
Challenges in Implementing a Counterparty Risk Management Process
The objectives of setting up a counterparty risk management process can be split into three categories – CVA pricing, exposure management, and regulatory requirements.
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.
The Evolution of Counterparty Credit Risk
Although the recent crisis has brought a heightened focus, counterparty credit risk theory and practice have been evolving for over a decade. Initially banks addressed the problem from their traditional financing experience while investment banks approached it from a derivatives perspective.
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.
Basel III and Systemic Risk
Basel III substantially raises the amount and quality of core Tier one capital from 2% to 7%, plus introduces an additional countercyclical buffer of up to 2.5% and a discretionary surcharge for ‘systemically important’ institutions, i.e., the big dealers.
Managing Credit Risk by Counterparty Selection
In cases where counterparties, e.g. prime brokers, do not post collateral and CDS protection is prohibitively expensive, hedge funds tend to manage credit risk through counterparty selection.
The Buy vs. Build Dilemma
There is no question that technology investment is increasingly a strategic rather than an operational decision. The question is not whether to use technology, but rather which one to use.
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