Valuation adjustments (XVAs)
Valuation adjustment is the umbrella name for adjustments made to the fair value of a derivatives contract to take into account funding, credit risk and regulatory capital costs. Dealers typically incorporate the costs associated with XVAs into the price of a new trade.
The oldest XVA is the credit valuation adjustment (CVA), which reflects the cost of hedging a client’s counterparty credit risk over the life of the trade. This includes the point-in-time view of CVA reflected in the profit and loss (P&L) statement, and the future volatility of CVA captured in the Basel III regulatory capital requirements.
Funding valuation adjustment (FVA) is the cost that arises when a dealer is unable to directly pass variation margin from an out-of-the-money client to an in-the-money client. The dealer then has to fund the margin itself, generating a cost.
Capital valuation adjustment (KVA) is the cost associated with holding regulatory capital against a trade.
There are also some valuation adjustments that are usually not explicitly charged to a client but are still seen as part of the XVA family. These include: debit valuation adjustment (DVA), which is reflected in the P&L statement as the dealer’s counterparty credit risk to the client; and margin valuation adjustment (MVA), which is the cost of funding the initial margin required to be held against a trade.
XVA calculations for the same trade can differ across banks, depending on their calculation methodology and existing portfolio. Many smaller banks do not charge clients for some or any XVA elements.
Larger dealers have specific desks whose job it is to hedge XVA exposures, while optimisation vendors offer services to help reduce them on a multilateral basis.
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