Re-Thinking CVA: Valuations, Counterparty Credit Risk and Model Risk

Dan Rosen; David Saunders

counterparty-book

The market price of over-the-counter (OTC) derivatives must reflect the credit risks faced by the counterparties. The credit value adjustment (CVA) is the market price of this counterparty credit risk. Some large banks began calculating CVAs in the early 1990s (Sorensen and Bollier 1994). Prior to the 2007–9 global financial crisis, CVA was generally ignored or too small to be noticed by most players, and mark-to-market losses due to CVA were not directly capitalised. However, CVA is now an essential part of derivatives business best practices, accounting standards and Basel III regulation (see, for example, Financial Accounting Standards Board 2006; Basel Committee on Banking Supervision 2010).

There is nothing simple about CVA in practice. Going from textbook exercises to the practical implementation is not straightforward: the definition is itself complex; models and calculations are involved; managing the resulting market and credit risks is difficult; and data will always be incomplete. Understanding the significance and impact of model risk is critically important when considering issues of valuation, hedging and risk measurement surrounding CVA.

CVA is pricing. But do

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