Financials

Counterparty Credit Risk- CVA,DVA And FVA

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<p class="reader-text-blockparagraph" style="background: white;">What is a CVA, DVA, FVA, and many such adjustments that get part of the pricing of the OTC Derivatives market to mitigate Counterparty Credit Risk? How they have changed with time and basic relevance of each of them, let's understand them . . .</p><p class="reader-text-blockparagraph" style="background: white;">In comparison to Exchange traded market where we have Credit risk mitigated by the Clearing House, the OTC Derivative market has a high Counterparty Credit Risk, 2008 Financial crisis was the best example. Regulators took quite a lot of measures to reduce counterparty credit risk, one of them was the mandatory clearing of vanilla OTC products especially the Interest Rate Swap that comprises of more than 80 % of OTC trading volumes and still working towards moving many other products on it .</p><p class="reader-text-blockparagraph" style="background: white;">In OTC markets, previously there was no formalized way of collateral exchanged to mitigate cpty risk. So there were high chances of default by either of the parties and other parties losing money. So if Party A and Bank B are trading an Interest Rate Swap where Party A has an unrealized profit and Bank B files for bankruptcy and defaults, Party A will have to book a loss. The opposite can also be true where Bank B is in Profit and Party A defaults. So from risk point of view, it&rsquo;s important to identify the overall exposure each party has overtime in terms of amounts in the future, probability of each party defaulting and also the amounts that will be recovered if any of the parties default, which is the base for the below :</p><p class="reader-text-blockparagraph" style="background: white;">From Party A point of view:</p><p class="reader-text-blockparagraph" style="background: white;">Credit Value Adjustment (CVA): Estimate of the PV amount lost if the Bank B defaults</p><p class="reader-text-blockparagraph" style="background: white;">Debt Value Adjustment (DVA): Estimate of the PV amount benefit if Party A defaults as Party A wouldn't have to pay to Bank B</p><p class="reader-text-blockparagraph" style="background: white;">CVA and DVA adjustments are also priced at the time when traders trade. For instance, if the IRS Swap rate is 5 %, CVA and DVA net is 2 % , IRS Swap rate if agreed by both parties it would be 7%.</p><p class="reader-text-blockparagraph" style="background: white;">If you hedge your position with a trade facing Clearing House and your current position is uncollateralized, even though you have hedged your position you will have to provide collateral when you are in loss on the hedge trade to Clearing House and will not receive any collateral on the original trade which is in profit, this will incur cost of funds, that's what a Funding Value Adjustment (FVA) is. You can also benefit if you are in profit on the hedge trade, you will get the margin money from Clearing House.</p><p class="reader-text-blockparagraph" style="background: white;">Regulations in various jurisdiction and specifically Basel 3 mandates firm to maintain additional capital for derivative position and there is cost of interest to be made to borrow the money for it which is called as Capital Value Adjustment (KVA)</p><p class="reader-text-blockparagraph" style="background: white;">Lastly, in recent times where Cleared as well bilateral OTC trades are collateralized , there can be a cost to the firm when the amount of interest paid to borrow money based on their firm riskiness and the interest it will receive they you provide the money as collateral differs which is known as Collateral Valuation Adjustment (COLVA)</p><p class="reader-text-blockparagraph" style="background: white;">All these adjustments like CVA, DVA, FVA, COLVA, KVA fall under the umbrella of XVA.</p><p class="reader-text-blockparagraph" style="background: white;">The calculation of these adjustments requires a lot of mathematical expertise and financial engineering and every organization has software that does these calculations. In the current market even though collateral is exchanged to mitigate your cpty credit risk, there is always a certain exposure left with the respective trading partner and that calls for risk management. CDS is one of the products one can buy due to hedge this credit risk on the particular company or Index of Bonds.</p><p class="reader-text-blockparagraph" style="background: white; box-sizing: inherit; margin: 3.2rem 0px; padding: var(--artdeco-reset-base-padding-zero); border: var(--artdeco-reset-base-border-zero); font-size: var(--font-size-large); vertical-align: var(--artdeco-reset-base-vertical-align-baseline); --artdeco-reset-typography_getfontsize: 1.6rem; --artdeco-reset-typography_getlineheight: 1.5; line-height: 3.2rem; color: rgba(0, 0, 0, 0.9); font-variant-ligatures: normal; font-variant-caps: normal; orphans: 2; text-align: start; widows: 2; -webkit-text-stroke-width: 0px; text-decoration-thickness: initial; text-decoration-style: initial; text-decoration-color: initial; word-spacing: 0px;">&nbsp;</p>
KR Expert - Mustufa Petiwala