CORPORATE FINANCE
CVA: Do you know you’re paying a credit charge on your trades?
The importance of quantifying and managing counterparty credit risk in the derivatives market has never been greater. One of the most important effects of the economic crisis on OTC derivatives markets has been greater attention to and valuation of the credit risk inherent in any derivatives trade. Credit Valuation Adjustment (CVA) is rapidly emerging as the industry standard.
t is now imperative that corporate treasury departments understand CVA and implement systems capable of handling it. Ultimately CVA will benefit the entire derivatives industry from dealers to end users by more accurately measuring the credit risk derivatives users are carrying. Corporate treasury departments which fall significantly behind the rest of the market will face several consequences ranging from misunderstanding the effectiveness of their funding activities to being taken advantage of by dealers at trade time.
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Levels of implementation and readiness for the transition to CVA based credit protection vary widely. The greatest level of CVA implementation is in interest rates. We can expect it to be gradually applied across all asset classes; this will enable coherent measures of credit risk across all derivatives activities within an institution.
Where: DefaultProbability(t) = the probability of the counterparty defaulting at or before time t, based on the counterparty’s CDS curve RecoveryRate = the expected recovery rate for senior creditors in the event of default ExpectedLoss(t) = The expectation of positive MTM as of time t i.e. integration over the positive MTM portion of the implied distribution To put this in simple terms, we are answering the following two questions: 1.What is the likelihood of my counterparty defaulting? 2. If my counterparty defaults, how much money do I expect to lose? For trades which fall under a CSA with a non-zero threshold, the cal-
CVA CALCULATION FOR A SINGLE TRADE
CVA is a probabilistic calculation of expected losses due to the potential for counterparty default for trades. First let us consider the calculation of CVA for a particular point in time between now and the final maturity date of a specific trade. The calculation for trades with no collateralization for time t is: CVA(t) = DefaultProbability(t) * ExpectedLoss(t) * (1 – RecoveryRate)
CHARGING FOR INHERENT COUNTERPARTY RISK
CVA is a critical component of derivative pricing, particularly for uncollateralized trades. It allows the adjustment of both mark-to-market valuations as well as new trade pricing to reflect the inherent counterparty credit risk associated with any trade which is not 100% collateralized.
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Table des matières de la publication Trésorier magazine - n°77 - 1er trimestre 2012