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Pay Floating
Bank A
Bank B
exposure.
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Mark-to-Market
In the money
Life of contract
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risk.
fixed interest
UBS
fixed interest
DB
floating interest
BAML
floating interest
UBS Trade
Net
BAML Trade
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Key terms
MtM
Adjustment made to the risk free value of derivative assets to reflect the default risk of the counterparty
Takes into account that in the event of counterparty default the firm will not realize the future value of the transaction.
Debit valuation adjustment (DVA) Adjustment made to derivative liabilities to reflect the default risk of the bank
This is the Probability of Default , the likelihood that a counterparty will default
2 forms: market implied and real world (often called historical PDs)
CVA
Mark-to-Market, current (default) risk free value of an OTC derivative, can be positive or negative for the firm
Related to replacement cost in case of counterparty default (exposure measurement)
DVA
PD
LGD
EAD
The loss that the firm would incur in the event of the counterparty default
This is the Loss Given Default
The exposure that the firm would have at default this is the current exposure plus any likely drawdown/increase in
lines that could occur before default, or changes in the exposure of derivatives or repo transactions, taking collateral
into account
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Managing &
Hedging
Accounting Rules
Capital
Requirements
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Netting Agreement
Spread exposure
across different
counterparties,
especially high
quality
Single legal
exposure allowing
the aggregation of
transactions with a
given counterparty
Margin &
Collateralisation
Hedging with
credit protection
Central
Counterparties
Transfer of
collateral (cash,
securities) when the
transactions market
value exceeds a
specified threshold
Buying CDS
protection with the
reference entity
being the
counterparty and a
notional equal to
credit exposure
Clearing Houses
reduce risk through
mutualisation of risk
and high levels of
collateral
maintained on a
daily basis
Other methods, such as quarterly reset clauses and break clauses are built
into contracts
Credit risk
mitigants are beneficial
but createCentral
other types of risk
Netting
Collateralisation
Counterparties
Operational
risk
Liquidity
risk
Systemic
risk
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Collateral disputes
Operational / settlement
failures
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What is CVA/DVA?
Recently introduced in financial accounts
Credit Value Adjustment (CVA) is the market value of the risk component
correcting for the Counterparty Credit Risk (CCR) in the value of the derivative
Debit Value Adjustment (DVA) is the market value of the risk component
correcting for the own credit risk in the value of the derivative
CVA was a major driver of balance sheet volatility during the crisis
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DVA
Still exposed to
default risk
The first step to calculate BCVA is the time and order of the banks and
counterpartys default, possibly in a correlated way.
Time of
default leads
to
B and C
default after
maturity
C defaults
before B
and
maturity
B defaults
before C
and
maturity
First to default: six possible scenarios which depend on the default time of
the Bank (B) and the Counterparty (C).
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Scenario 1
Default B
Default C
Maturity
Time
Scenario 2
Scenario 3
Default B
Default C
Default C
Default B
Maturity
Time
CVA
Time
No impact
Scenario 4
Default C
Scenario 5
Scenario 6
Maturity
DVA
Default B
Default B
Default C
Default C
Default B
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CVA components
CVA is the incorporation of the cost of the counterparty credit exposure in the
value of an OTC derivative, i.e. cost of a potential credit loss arising from
future counterparty default
The risk of credit loss arising from future counterparty default is driven
by market risk factors and
by the PD and LGD of the counterparty, and
by credit risk mitigation (netting, cash margining and collateral)
Potential future credit loss = (future MtM future collateral) - recovery
Future positive MtMs only are considered in the context of CVA
In the absence of dependence between the credit worthiness of the
counterparty and the exposure, the CVA can be written as :
EE is average over a
given time bucket of the
(netted) MtM, if positive
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DVA Definition
Debit Value Adjustment is the adjustment made to derivative liabilities to
reflect the default risk of the bank and the market value of non-performance
risk
Debit Value Adjustment (DVA)
In theory, mirror image of CVA
The exposure component of the credit risk equation is subject to changes
depending on movements in market risk factors
A decrease in the credit-worthiness of the bank leads to an increase of the
mark-to-market of the portfolio causing a profit.
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Position
Reference
Position Re-Valuation
Exposure Calculation
(EAD/EPE/PFE/etc.)
Pricing Models
Market
Approximate
Pricing Models
Bilateral default
WWR calculator
CVA/DVA
Data
Risk Factor
Simulation
(Default)
dependency
Data
CDS prices
CDS Data
Bootstrapping
PD/LGD profiles
Benchmarks
LGD Info
Obligor mapping